Valuation Analysis in Commercial Real Estate:
What you need to know.
Understanding how real estate valuation analysis works is essential in deciding whether to invest in a property. Is your investment in an identified piece of real estate of financial value to you? Will it generate a worthwhile Return on Investment? Good questions.
This is one of the biggest reasons working with a commercial real estate specialist is so important. Unlike residential real estate, commercial real estate often involves complex income and expense variables not encountered in the residential real estate space.
Why Do You Need a Commercial Real Estate Valuation?
Financial lenders will require a commercial real estate valuation report before they can decide to provide you with financial backing. To mortgage, lease, buy, sell, develop, sell, or insure the property, investors rely on property valuation reports.
Valuing Commercial Real Estate
Estimation of the value of real estate property is complex as each property has its unique characteristics. Understanding the basic concepts and valuation methods utilized by experienced real estate agents will give you more confidence and security in your investment decisions. Approach experienced professional commercial real estate surveyors and valuers to provide an accurate valuation based on unique market characteristics.
Real Estate Valuation Terms to Know
- Income and Expenses
- Net operating income (NOI)
- Cash flow
- Cash-on-cash return
- Capitalization rate (Cap Rate)
- Property value
Income and Expenses
Income obtained from rents, lease payments by tenants, and late fees, and other means. Expenses are operational costs paid for property insurance, property management fees, tax fees, and others.
Net Operating Income
Net Operating Income (NOI) analyzes the profits of the total income less essential operating expenses from commercial real estate investment. A simple formula is:
Net operating income (NOI) = Total Income – Operating Expenses.
When a property’s NOI rises, so does the value of the property, and vice versa.
Cash flow is the property’s NOI, less debts such as mortgage payments. Calculated as:
Cash Flow = Net operating income (NOI) – Mortgage payments
Cash on-cash return or equity dividend rate is the ratio (usually expressed as a percentage or yield) derived from annual cash flow (before tax) divided by the actual equity investment. It’s a simple formula:
Cash-on-cash return = Annual cash flow / Purchase Price (on actual cash invested)
Capitalization Rate (Cap Rate)
Capitalization rate or Cap Rate is an estimation of the potential return on a real estate investment. Its best understood as the measure of risk:
Cap Rate = Annual Net Operating Income (NOI) / Current Market Value (Sales Price)
The higher the Cap Rate, the higher the risk (low-demand areas), the higher potential return, and the lower the property price and vice versa. Investors are more likely to pay more for low-risk property (high-demand areas) with greater chances to continue appreciating and generating more income.
Property value refers to the fair market valuation of a particular piece of real estate based on the price agreed upon by the buyer and seller. Calculated as:
Property value = Net operating income (NOI) /Cap Rate
The higher the property (market) value, the higher the purchase price.
I am often asked how much a commercial real estate property is worth from clients interested in buying commercial property. My answer is it depends on your investment objectives, property type, and local market conditions.
There are 3 basic approaches to estimating the market value of a commercial property: sales comparison, cost approach, and income approach. Each of these commercial real estate valuation methods has numerous variations so it’s important to apply the right approach based on the property type and market characteristics.
Sales Comparison Approach to Market Value
The sales comparison approach relates the value of a property to similar properties that are currently listed for sale or that have been sold historically. Realistically no two properties are identical so adjustments need to be made for the differences in the age, size, location, condition, building/land ratio, zoning, tax policies, date of sale, and other characteristics and conditions that would influence a property’s market valuation.
Adjusting the comparables for each variance will allow you to select the values, giving greater weight to the comparables more similar to the subject property. The more similar, the more reliable they are considered. At the end of the day the sales comparison approach is the price a purchaser is willing to pay and the seller is willing to sell for in an open competitive market.
The sales comparison approach works best when there are plenty of recent sales of comparable properties. The more properties that have recently sold makes it easier to find and select the most comparable.
Income Approach to Market Value
The income approach is is applied on income producing properties and is based on the premise that a relationship exists between the income a property produces (future benefits) and its value. The net operating income that an investor can predict will be generated for the length of ownership would be considered the future benefits. Two methods used to determine value based on income are the direct capitalization method and the discounted cash flow model.
Direct Capitalization Method
This method converts a one year stabilized net operating income (NOI) into a market value for the property. The formula is V = I/R. For example if you know the NOI is $50,000 and the asking sales price or sold price is $500,000 then you know the Cap rate is 10%. Then you compare the cap rates of all the comparable properties.
Discounted Cash Flow Model
This is a variation of the Cash Flow Model and used when uneven cash flows are anticipated. This model determines property value by discounting each years NOI and final sales proceeds to a present value (PV)
The most likely to purchase income producing properties are investors which is why the income approach is the best choice to value non owner occupied properties.
WHAT IS VALUE ADD COMMERCIAL REAL ESTATE
Commercial real estate investors can make big bucks by doing what is called Value Add commercial real estate deals. The most successful commercial real estate investors look for value add deals. This is where millions can be made. In this post, we’ll go into detail exactly what is Value Add commercial real estate, and how to add value to commercial real estate properties. Let’s get started!
WHAT IS VALUE ADD COMMERCIAL REAL ESTATE?
Value Add commercial real estate is exactly as it sounds. Value add commercial real estate is when investors add value to their commercial property. Value can be added to all types of commercial real estate. Value can be added to apartment buildings, shopping centers, retail centers, office spaces, industrial warehouses…seriously, any commercial real estate property is eligible to be Value Add commercial real estate. Basically, value add commercial real estate is when you add value to the property through various things.
One of the best ways to increase property value is to increase the Net Operating Income, or NOI. As the NOI increases, so does the property value. Net Operating Income is the rental income collected minus operating expenses.
HOW TO INCREASE NET OPERATING INCOME
Commercial real estate developers and investors can increase their net operating income in several ways. The first is simply increasing rent when leases expire. Investors can also bill tenants for utilities associated with the property, thus taking the burden off themselves, while increasing cashflow. Property owners should also look to make their operations more efficient by hiring the best possible property management company available. All of these steps can help reduce expenses while increasing your net operating income, which in turn increases the value of your commercial real estate property.
ADDING VALUE TO COMMERCIAL REAL ESTATE
As we’ve mentioned before, investors choose commercial real estate because commercial real estate provides high yield returns consistently. However, many investors look to increase those returns by adding value to their properties. Adding value to a commercial real estate property is done in two ways; adding value by market appreciation and adding value through property improvements.
ADDING VALUE BY MARKET APPRECIATION
The first way that commercial real estate owners increase the values of their property is to allow the forces of the market to slowly increase the value. If you’re a good operator and consistently raise rents to keep up with the general market, in 20 years, by making no improvements or adjustments, some commercial properties can literally double in value. Simply by allowing time to run its course, most commercial real estate rises slowly in value thanks to market appreciation. There is always the risk that the market could see a downturn, but normally, as with all real estate, property values increase over time.
ADDING VALUE THROUGH PROPERTY IMPROVEMENTS
Instead of simply waiting for the market to appreciate over time, you can increase the value of a commercial property by applying “value adds” to it. For example, in an apartment complex, you could remodel the kitchen (installing granite counter tops, stainless steel appliances and tile floors, etc.). These improvements allow you to charge more in rent and that increase in rental income can increase the NOI and when the NOI increases, so too does the value of the property. When you add value to a property through improvements or other such adjustments, that’s called a “value add” deal…because you added value. The most successful commercial real estate investors look for properties that have great “value add” potential.
How To Determine Commercial Property Value?
Buying or selling a commercial property is an important decision, and a buyer should be well informed on how to determine its value.
Commercial properties are often expensive and demand a hefty initial financial investment. However, there are ways you can save money by researching the real estate market before purchasing a building. For that, you will need to understand what factors influence your decision and learn more about the industry.
By learning about commercial real estate values, you will be able to protect yourself from overpaying for a building while also ensuring that you are not underpaid if you sell your property.
This blog will help you determine the worth of your next commercial property purchase or sale.
Factors Affecting Commercial Property Value
When determining the commercial property value, you will need to consider the factors that affect this type of valuation.
One of the most critical factors in determining the value of a commercial property is its location. The property’s location can affect many different aspects of your building, such as traffic flow, surrounding comparable buildings, and local businesses. It could either help increase or decrease the value of the property.
Age of Building
Another essential factor to consider is the age of your building. Older and well-maintained properties can sometimes even be more valuable than newer ones, especially if it only has minor wear and tear on them. However, this depends on the type of commercial real estate you own. Further, the age of your property will likely determine the classification of your building – another buying or selling factor to keep in mind.
Condition of Property
The condition of the property will also affect the building’s worth. For example, if renovations or repairs have been done on or to the property, it could increase its value, especially if these changes were beneficial to the overall real estate market. Things like landscaping, upgraded and updated lobby restrooms, or general security upgrades all increase the value of the property.
Proximity To Services
Commercial properties can often benefit from proximity to local highways or public transportation systems. This attracts more customers who drive by during their daily commute. Moreover, nearby amenities such as convenience stores, shopping malls, and entertainment values, or lack thereof, can affect a property’s value.
Lease Terms and Length of Lease Term
If you are buying or selling your commercial property, another essential thing to consider is the terms of any current lease agreements. A building’s rent roll will demonstrate its current earnings.
The term length can affect how much money a building is worth because if there are many months left on a or several long-term lease agreements with high rates per month, it may be hard for someone else to try and purchase the building. However, if they offer enough money, it will pressure you as an owner to sell quickly before losing out altogether.
Commercial Real Estate Valuation Methods
There are several ways to determine what your commercial real estate might be worth when looking at its value compared to other properties in its area. These are what we call comparables.
By understanding these methods better and the factors affecting the price, you will be able to make a more informed decision.
This valuation method is generally used when you are considering to buy and or sell properties that are already built and in use. This approach uses the price of the land plus the cost of building construction minus depreciation.
The cost approach is less reliable than other valuation methods. However, it is the most accurate of the five different methods when the property taken into account is a new build.
Sales Comparison Approach
The sales comparison approach is a method that uses information from similar properties in the area to determine what your commercial real estate might be worth. Sales comparison includes looking at square footage, the number of floors/rooms, amenities, and other individual features.
The comparison can also include recent sale prices for nearby buildings or plots of land, giving you an idea of how much someone else might pay for the property. You can then use these factors when working out a fair price with any interested buyers.
Income Capitalization Approach
The income capitalization approach, commonly known as the income approach, uses the net operating income, or NOI, as a way to determine what your commercial real estate might be worth.
This valuation method is typical for existing buildings. It can estimate how much an owner may ask for their property based on rental rates and expenses such as repairs, insurance costs, and taxes associated with owning said building.
Value Per Gross Rent Multiplier
The value per gross rent multiplier method is a general approach used to determine the market value of commercial properties. This method uses a multiplier to determine the value of the building relative to its gross annual rental income. Therefore, it is essential to know the gross rent multiplier of similar properties within the area for comparison purposes.
Value Per Door
The commercial real estate value per door method is also prevalent since it is quick to compute. This approach will calculate the entire building’s worth based on the number of units in the building. It will then be compared to other properties for sale or currently up for lease agreements.
This method allows you to measure the potential price that an interested party may pay to purchase this property. You base the value on the amount it might take you as an owner to sell at current market prices while comparing your numbers against similar buildings available for sale or rent.