How Do You Value Commercial Real Estate?
Commercial real estate comes in a wide variety of options, from standalone buildings to multi-story office complexes. Some buildings are purpose-built for a single use while others are ready platforms for a wide array of businesses. In addition, properties in some locations can be more profitable than others. Given all of these factors, how can you determine a good price for a piece of commercial real estate?
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How Do You Value Commercial Real Estate?
Commercial real estate valuation involves considering the building itself, including its number of units, age, location, and its square footage. However, buyers must also consider the cost to reconstruct the building in a new area, the revenue generated by tenants, and its historic return on investment. Unlike residential real estate, many of the factors in commercial real estate are uncontrollable and can be harder to quantify.
What Are the Best Commercial Property Valuation Methods?
For this reason, a commercial real estate’s appraised value can be calculated in multiple ways. Five standard ways to do this are: Cost Approach, Sales-Comparison Approach, Income Approach, the Value per Gross Rent Multiplier, and Value per Door.
1. The Cost Approach
The cost-approach is a method that calculates the cost to rebuild an entire property from scratch. It’s an approach that can involve aspects such as labor costs, construction materials, land, and other components like roofing, HVAC systems, insulation, and more. The way to calculate these expenses can be done on either on an individual and joint-based level. For example, one might analyze what it would cost to rebuild the entire complex versus a few units, or a few units versus specific components of each individual unit.
Essentially, though, the cost-approach considers the land’s value, the costs to reproduce a similar type of unit that follows the same standards and materials. it also factors in the value of any new improvements or additions and depreciation. The reconstruction of a similar type of unit is defined as cost new. The depreciation is derived from the comparison between the current value of those improvements versus the future value of the improvements.
In other words: the cost-approach = (Cost New – Depreciation) + Land Value. The total will tell you the commercial property’s estimated value. This approach isn’t common. Still, a buyer may consider this approach when the property is new, there are specialized improvements made to the building, or there isn’t an active market.
2. The Sales – Comparison Approach
If there is an active market for properties useful for your business, one might use the sales-comparison approach. The sales-comparison approach is simple in theory. It compares and contrasts the current sales data of similar properties, in size, location, zoning / use type, and age.
The problem with this approach is that each area is different and influenced by a conglomerate of factors. If an appraiser can find a property, but it’s far beyond the intended market area, the approach can result in some unreliable comparisons.
The “Sales-Comparison Approach” is more commonly used to determine residential real estate value versus commercial real estate value. Yet, if one can find property in the area, it’s a fast method that can provide good insight into your commercial real estate’s value.
3. The Income Approach
The income approach is a forward thinking method that’s perhaps best summarized in the motto: invest now, reap later. This method involves comparing the business’s potential future income with its current costs. Its two main factors are the net operating income and the capitalization rate.
- Net operating income (or NOI) is determined by subtracting the expenses to maintain or re-construct the business from its potential annual income. That potential income stems from details, such as the property’s intended rent charges or customers.
- The capitalization rate (or CAP rate) is the expected gain or loss of an investment; it’s a percentage. It is found by dividing the NOI by the property’s initial purchase price. An appraiser might use such an approach when trying to determine the value of apartment block.
Note, though, that this CAP rate can change based on the type of property, the area’s demographics and economics, and the market influence. That is to say, a CAP rate for a commercial center in Chicago, Illinois would be entirely different for a similar center in Las Vegas, Nevada because many factors can change (rental rates, demographics, land cost, market, etc.).
4. The Value per Gross Rent Multiplier
The gross rent multiplier (GRM) also an approach that considers the current costs of purchasing a building with the potential future income from it. However, the numbers that are used are based on the property’s annual gross income—before adding in property taxes, insurance, and utilities. This is different from The Income Approach that uses numbers that emerge after property taxes, insurance, and utilities are deducted from the annual income.
The GRM equation is as follows: Property Price/Gross Annual Rent = GRM
This approach is ideal when comparing the GRM with other GRMs for similar properties in the area. You may use it when you want to gauge how much to sell your commercial real estate for. But, the issue with this approach is that it does not account for many variables. For example, taxes and insurances as well as mortgages can change in an instant, resulting in a completely different annual income than expected.
5. The Value per Door Approach
The final method is called the value per door approach. This approach literally determines the value of a commercial property based on its number of units. The more units that a commercial property owns, the higher the value of the commercial property. Therefore, if a storage facility had 150 units each priced at $20,000 per unit, the entire storage area might be valued at $3,000,000.
The problem with this approach is that it assumes that all units are equal in terms of their income. It does not consider, for instance, that someone might want a larger storage unit and thus could generate higher income.
Fair Market Value of Commercial Property in Las Vegas
Fair market value (or FMV) describes the monetary value of a property in both a competitive and open market. It’s different from the property’s appraised value, which is the actual value of a home based on a singular appraisal’s calculations. The fair market value is the most competitive price a buyer would pay for the property—assuming that the property meets all the demands and needs. FMV is often a range between the lowest and highest potential selling price. The FMV can change depending on the demand and area.
A commercial property in New York City may have a much higher FMV than a similar business in rural Indiana. This is because there is higher taxes, but also more opportunities for businesses in New York, hence a higher chance to reap income. Thus the market value of commercial property in New York City is higher—even if the actual NYC commercial property has a lower appraised value than the one in Indiana.
In Las Vegas, the opportunity for a fair market value is greater because of such factors like the area’s low cost of living and lack of state income taxes. If one is new to an area, it’s ideal to get updated data about the local commercial real estate market. One way to do this is to work with companies, such Graham Team Commercial Real Estate, a privately-owned firm that specializes in gathering such data in the local area. Such businesses can not only provide current data of the local area, but also help to identify the potential future of your commercial property.
This is ideal if you are new to the commercial real estate property, but especially if you are new to the area that you’re planning on purchasing or selling commercial real estate in. By checking in with an organization like Graham Team Commercial Real Estate, you increase the likelihood of better understanding your market. This understanding can help you achieve your commercial real estate goals. As a result, it can positively impact you and your success as well as others and their businesses, too.