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.
Types of Commercial Real Estate Value
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.
- Market Value: This is the value that is used for purposes of loan underwriting. The Appraisal Foundation sets a specific definition for this term, as stated in the USPAP or Uniform Standards of Professional Appraisal Practice. According to it, a property’s market value is the “most probable price” it would fetch in a fair sale in an open competitive market, with both the seller and buyer acting with knowledge and prudence.
- Investment Value: This refers to the value of a CRE property to a specific investor based on their requirements, financing, tax rate, and other such specific and unique factors. It is much more subjective compared to market value.
- Insurable Value: Used to determine insurance coverage, this refers to the value of a commercial property’s destructible portions.
- Assessed Value: Used for levying real estate taxes, this refers to the asset’s value as determined by the tax assessor.
- Liquidation Value: This is the price that a CRE property would most likely sell for in a forced sale scenario, as in the case of a tax sale or foreclosure. It is used when there are restrictive sale conditions or when there is a limited market exposure window.
- Replacement Value: it is the cost to replace the structure with something identical or something with the same utility as the original structure.
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.
Approaches to a CRE Property’s Market Value
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:
- Cost approach: This approach is based on the property’s replicating cost minus occrued depreciation (physical deterioration, external obsolescence, and functional obsolescence). The replacement cost is computed, and any accumulated depreciation is deducted, then the cost is added to the land’s value to determine a suitable value based on cost.
- Income capitalization approach: This approach derives the value of a property from the income it produces.
- The sales comparison approach links a commercial property’s value to what recent buyers paid for similar commercial properties. While no two real estate assets are exactly alike, this approach can provide a reasonable value estimate when many recently-sold comparable transactions are available.
In a full appraisal, all the values discussed above are reconciled using a weighted average, ultimately determining the final value estimate.
Approaches to a CRE property’s investment value
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:
- Gross rent multiplier (GRM) – This ratio determines investment value by multiplying the market-based GRM by the gross rents the property produces in one year. The GRM is derived from comparable CRE properties in the same submarket.
- Comparable sales (also called comps) – This approach is the same sales comparison method used by professional appraisers (discussed above). Most investors compare similar CRE assets on a per unit or per square foot basis.
- Cash on cash return: This ratio is calculated by dividing the proforma cash flow on the first year before tax with the initial investment.
- Discounted cash flow: This is used to compute an internal rate of return, capital accumulation comparison, and net present value.
- Direct capitalization: This approach is the same as the direct capitalization method used by professional appraisers (discussed above). Capitalizing a property’s income stream is a simple and common way to determine both the commercial property’s investment and market 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.