Commercial Real Estate Valuation in 3 Steps

 

 

 Commercial real estate is an attractive investment option that has the potential to generate long-term income and appreciation. However, determining the value of a commercial property can be a complex process. There are three common approaches to valuing commercial real estate: income approach, sales comparison approach, and cost approach. In this blog post, we will delve into the details of each of these methods.

1. Income Approach

The income approach is one of the most common methods used to value commercial real estate. This approach is based on the idea that a property's value is determined by the amount of income it generates. In other words, the income approach values a property based on the income it is expected to produce in the future.

The income approach typically involves three steps:

Step 1: Estimate potential income

The first step in the income approach is to estimate the potential income that the property could generate. This involves analyzing the rental income, occupancy rates, and other revenue streams that the property could generate in the future. This estimation is typically based on market trends, comparable properties, and the property's own historical data.

Step 2: Determine operating expenses

Once the potential income is estimated, the next step is to determine the operating expenses of the property. This includes items such as maintenance costs, property taxes, insurance, and management fees. Subtracting these expenses from the potential income will give us the net operating income (NOI).

Step 3: Calculate the property's value

The final step is to determine the property's value using the NOI. This is typically done by dividing the NOI by a capitalization rate (cap rate) that is appropriate for the property and the market. The cap rate is a measure of the property's risk and return and is determined by comparing it to similar properties in the area.

2. Sales Comparison Approach

The sales comparison approach is another popular method used to value commercial real estate. This approach is based on the idea that a property's value is determined by its market value relative to other similar properties in the area.

The sales comparison approach typically involves three steps:

Step 1: Identify comparable properties

The first step in the sales comparison approach is to identify comparable properties in the area. These are properties that are similar in terms of size, location, age, and other relevant features. This step involves research and analysis of recent sales and listings.

Step 2: Adjust for differences

Once comparable properties are identified, the next step is to adjust for differences between them and the subject property. These adjustments may include differences in size, age, location, and other features that affect the value of the property.

Step 3: Calculate the property's value

The final step is to calculate the property's value based on the adjusted values of the comparable properties. This is typically done by averaging the adjusted values of the comparable properties and applying it to the subject property.

3. Cost Approach

The cost approach is a method used to value commercial real estate based on the cost of replacing or reproducing the property. This approach is typically used for properties that are new or have been recently renovated.

The cost approach typically involves three steps:

Step 1: Determine the cost of the land

The first step in the cost approach is to determine the cost of the land on which the property is built. This involves analyzing the market value of similar properties in the area and estimating the cost of developing the land.

Step 2: Estimate the cost of construction

Once the land value is determined, the next step is to estimate the cost of constructing the building on the land. This involves analyzing construction costs, labor costs, and other relevant expenses.

Step 3: Adjust for depreciation

The final step in the cost approach is to adjust the estimated cost of construction for depreciation. Depreciation is the reduction in the value of the property due to wear and tear, age, and other factors that can lower the property's value over time.

Depreciation can be classified into two categories:

1. Physical depreciation - This refers to the loss in value due to wear and tear, damage, and other physical factors.

2. Functional obsolescence - This refers to the loss in value due to changes in design or technology that make the property less desirable or functional than newer properties.

To adjust for depreciation, the estimated cost of construction is reduced by the amount of depreciation that has occurred since the property was built. This adjustment is based on the age of the property, its condition, and its market demand.

After the cost of construction has been adjusted for depreciation, the final value of the property can be determined. This is typically done by adding the value of the land to the adjusted cost of construction.

In conclusion, valuing commercial real estate can be a complex process. The income approach, sales comparison approach, and cost approach are three common methods used to determine the value of commercial properties. Each of these approaches involves several steps, including estimating potential income, identifying comparable properties, and determining the cost of construction. By understanding these methods, investors and real estate professionals can make informed decisions when buying, selling, or investing in commercial real estate.