Commercial properties are evaluated differently from homes. Therefore, if you are thinking of investing in commercial real estate, it’s essential to understand how to use the three main approaches to establishing the value of a CRE asset. Let’s talk about them in this blog.
#1: The Income Approach
To use this approach in commercial real estate evaluation, you need to take the capitalization rate (cap rate) and divide it by the income the property generates. There are five steps to doing this:
- Determine the approximate ‘gross potential income’ of the commercial property if it is 100% occupied.
- Determine the approximate ‘effective gross income’ by looking at the probable vacancy costs of similar properties in the exact location or general area.
- Total up the property’s fixed and variable expenses, making sure to include utilities and management fees.
- Calculate the net operating income (NOI). This is done by taking the adequate gross income and deducing all estimated expenses. This computation can only be done after deciding on a reasonable cap rate based on the market sales of like properties in the area and the general market.
- The last step is cap rate application. Now that you have the property’s NOI, it’s time to apply the cap rate for the product type and the market. You can do this by taking the cap rate and dividing it by the NOI. The result will give you an estimate of the commercial property’s value.
Do note that even if a prospective commercial real estate asset seems like a great deal in terms of the cap rate, it’s still important to see how it fares against other valuation methods, including the following:
- Gross income refers to the total amount of money that the commercial property brings in before expenses are deducted.
- Net operating income is the income the property brings in when all of the operating expenses (including vacancy costs) are deducted and before the monthly mortgage is paid.
- Cash-on-cash return – Expressed as a percentage, the cash-on-cash return can be computed by taking your down payment on the property and dividing it by the annual cash flow generated by the asset. This metric is another measurement of the property’s return on investment.
- Cash flow refers to the net amount of money you can pocket after all mortgages and expenses are paid.
#2: The Sales Comparison Approach
The sales comparison approach is often described as a backbone of comparative market analysis in the world of real estate. Also called the Market Approach, this method of estimating the value of a commercial property is particularly useful for multifamily buildings and other large-scale apartment rentals.
To use it, look at the sale prices of like-properties sold recently in the same area. These properties are called ‘comps’ or comparable. Make sure that they are within a short distance of the commercial property you want to evaluate and that they share similar characteristics that you can use as points of comparison.
The approach involves looking at demographics, infrastructures, leasing trends, and other factors that can profoundly impact the value of the property. It’s also important to look at physical features, including the size, the age of the structure, its condition, and other essential elements.
As you can see, there’s a long list of characteristics that investors and appraisers look at when evaluating the value of a commercial property. Let’s talk about some of the most common ones used in this approach:
- Neighborhood and location – Geography can directly affect the value of a commercial property.
- Recently sold listings are a great starting point for assessing the value of similar commercial assets in the area and can give you a good baseline number.
- Age and condition – The condition of a commercial structure will significantly influence an appraisal.
- Features – Ideally, commercial property should be compared with buildings with the same number of units, bathrooms, and other features.
- Average price per sq. ft. – Once you’ve compiled similar properties, divide their sale prices by their square footage. The resulting number is the cost per sq. ft. You can then take the average cost per sq. ft. for all comps and multiply this by the size of the appraised property.
It’s important to understand that the sales comparison approach is not an exact science. Outside factors, including the job market, the overall state of the commercial property market, and the status of the economy, can all impact how much commercial property is sold for and how long it takes to sell.
While the sales comparison approach can be helpful, it is by no means an official appraisal. You will need to request a formal review from an unbiased and independent professional appraiser for the most accurate results.
#3: The Cost Approach
This method of evaluating a commercial property is handy for buyers who may be hesitant about buying a building that they think might cost less if they built it from scratch. It is also often used in evaluating new constructions.
In this approach, the commercial property’s value is equal to the sum of (1) the value of the land on which it sits and (2) the costs of construction minus depreciation.
This approach allows buyers to see if they are spending less by buying a commercial property that has already been built instead of constructing it from scratch. It is commonly applied to commercial real estate assets that are tricky to sell because they have particular uses, such as hospitals, schools, gov’t buildings, churches, and libraries. In addition, these assets generate little to no income, so the sales comparison and the income approach cannot be used on them.
Construction lenders often require the cost approach because any income value or market value is contingent on project standards plus completion.
Construction projects are usually reappraised at different stages of the building process before funds are released for the next completion stage. Insurance appraisals also typically use the cost approach in underwriting policies.
Interestingly, many experts say that a cost approach appraisal can reveal whether or not it is the right time to buy a specific property. If the resulting evaluation comes in below market, the market may be overrated.
And conversely, appraisals above-market pricing may indicate a buying opportunity. This does not apply when the commercial property is either over-improved or under-improved for its location.
In this case, there’s a need to accurately estimate the value of improvements in order to precisely determine the value of the property—and this is not possible using just this approach.