In the world of commercial real estate or CRE, you will come across various types of "value" assigned to a property, each serving different purposes to different parties.
Value is an important consideration when applying for a CRE loan or doing any type of analysis on a CRE asset, so you have to understand its many varieties and when to use them.
This blog will discuss the different kinds of real estate value and then focus on the differences between a CRE asset's investment value and its market value.
So how is the "market" different from the "investment" value? If you're looking for a short answer here, it is:
Market value refers to the value of commercial property in the open market, as determined by a professional appraisal.
"Investment" value, on the other hand, is determined by the CRE investor based on his or her unique investment criteria and goals.
There are various kinds of value given to commercial real estate assets.
Let's go through them one by one, so you can get a bird's eye view of each, and then zero in on the investment and market value—the types that are most often confused by CRE investors.
CRE properties can have any or all of the above value types at any given time, and no two values have to be the same.
A professional appraisal determines market value, and this appraisal is typically done during the CRE loan underwriting process, as almost all lenders require it.
The market value estimate is used to determine the appropriate collateral value and loan amount.
But how do appraisers decide on a property's market value? The first step is to determine its highest and best use—the legal use that will yield the highest value.
Appraisers do this by evaluating the local zoning laws to figure out what uses for the property are legally permitted.
Once this is understood, appraisers then consider the physically possible uses within the limits of applicable zoning ordinances and the property's physical limitations, including its topography, layout, size, etc.
Finally, appraisers consider the financial feasibility for all of the legal and physically possible uses.
The highest and best use is the financially feasible use that yields the highest monetary return.
After determining the highest and best use, appraisers then compute the market value.
They may use any of the three basic approaches: cost approach, income capitalization approach, or sales comparison approach. Here's a summary of each one:
In a full appraisal, all the values discussed above are reconciled using a weighted average, ultimately determining the final value estimate.
The market value is useful for loan underwriting purposes. Investors are deciding how much money to pay for a CRE property look at its investment value—the amount that an investor is willing to pay given their investment objectives.
Investment value is, therefore, unique to each investor. Different investors can use the same valuation methods, but the resulting investment values will be vastly different.
There are various valuation methods for determining investment value, and investors can choose whichever they like (unlike professional appraisers who are required to follow stringent procedures). Here are the most common approaches to investment value:
As a CRE investor, you want to know a property's market and investment value before proceeding with any transaction, and certainly before applying for a CRE loan.
The safest policy is to ensure that a deal makes sense from both a market and investment value perspective.
Do note that investment values are much more subjective than market values, and as such, they can be abused.
You can avoid becoming a victim of investment value abuse by always estimating market value when there is a relevant market.
Tread cautiously if certain parties are claiming that the investment value is different from the property's market value in a way that supports their sales pitch.
While they may be right, it's still best to do your digging and verify their claims.