When I started as a residential realtor, it was fairly simple to price a house. And if I wasn’t sure where to start, I could just double-check Zillow.
However, when I became a commercial realtor, I quickly learned that the metrics involved when determining the value of a commercial property or an income-producing apartment building are much more complicated than the metrics when evaluating a house. With commercial and income-producing property, the valuation can be approached in several ways.
What are the methods for determining the value of a commercial property?
1. Income Approach
The income approach examines the value of the leases and income that the property can bring in and then applies a CAP rate valuation to the net operating income. Current interest rates influence the CAP rate, and a higher interest rate environment provides a lower cash-on-cash return (generally speaking). This will press investors to offer a higher CAP rate, which will translate to a lower price.
2. Sale Price Per Square Foot Approach
Because commercial properties are rarely similar sizes within a geographical area, the industry uses a price per square foot metric to help “equalize” the values. This allows for better and fairer comparisons between properties.
For example, let’s say a 4,000 SF retail building and a 6,000 SF retail building both recently sold. Breaking the numbers down into price per square foot allows you to place an appropriate value on the 5,000 SF building you’re evaluating.
Apartment buildings are often compared on a price-per-unit basis instead of a price per square foot, as the per-unit method provides a more accurate comparison of value in this category. Apartments are commonly more uniform in size than other types of commercial space within income-producing properties. If I told you that an apartment building held 10 studio apartments, you would have a good idea of what size those units were, whereas if I told you that an industrial property held 10 units, you couldn’t begin to guess what the sizes were – and the unit sizes can be inconsistent within that one property.
3. Replacement Cost Approach
The replacement cost method looks at the construction cost to rebuild the structure at today’s value, and then factors depreciation on that new construction number to account for the subject property’s age to arrive at an apples-to-apples comparison.
This valuation method is used less often but is a helpful tool to provide a second look if the income valuation is not applicable.
The replacement cost approach is most commonly used in redevelopment properties. If you have an older building in a great location, we would likely analyze the value with this method to determine the “highest and best use”.
For example, let’s say your subject property is a vacant industrial building in a great location that’s close to the very walkable downtown area of a city. Likely, the best use for this property is redevelopment into retail or apartment units. The replacement cost approach allows us to take the construction costs and then establish a value based on the income approach. The difference between the construction cost and the final value number then provides the value for the existing building.
- The building is 100,000 SF.
- It would cost $180 per SF (for a total of $18 million) to redevelop the existing building into a mixed-use retail and apartment property.
- The finished value of the property provides a net operating income of $1.4 million.
- The income of $1.4M at a 7% CAP rate gives us a value of $20 million.
- The value of the existing industrial building is the remaining amount: $20M – $18M = $2M
Pro forma income valuations are always nice to consider, but the time value of money should be taken into account as well. If it would take several years to earn the same income from an established property, a discount for the time and effort is appropriate. In this way, the replacement cost approach is a crucial step to understanding a property’s value.
How do you decide which metric to use?
You will likely hear a commercial realtor talk about a property’s “highest and best use”. This is a way for the realtor to decide which method is appropriate for determining the value of a commercial property.
Deciding which valuation method to use can sometimes be obvious, depending on the property. However, it can be more challenging to find the right pricing for a multi-tenant building with vacancies.
Would a conversion be the best fit? This takes into consideration the cost value, as the price per square foot for the renovation will determine the base price of the building that the market can withstand.
For example, let’s say your subject property is a mixed-use building with three commercial tenants on the ground level and three apartments above. Two of the commercial spaces are vacant, but the rest of the property is rented.
- The price per square foot approach would be the first step, as the vacant commercial space may be occupied by an owner-occupant who is not considered income on the rent role.
- The second step would be to create an income valuation, which assumes fair market rent for the vacant commercial space and the current rents for the rest of the property.
- Third, you’ll want to keep in mind that commercial leases may be under market value and locked in for a long period. If that’s the case, it’s essential to use the current rent and not the forecasted rent when doing the valuation. This may result in a lower value than the price per square foot method, but the lower income is an important factor that negatively impacts the overall value of the building and is only accounted for with this approach.
Also, you’ll need to consider if the vacant land has more value than the buildings. Understanding the value of the land would involve examining the zoning, location, and need for vacant land within the market. This helps to determine if a different use for the property would be it’s highest and best.
When determining the value of land, the highest and best use is usually the one that will provide the best pricing. For example, you may have commercial land that allows for self-storage, townhomes, and retail under its zoning. Examine the income approach by building pro formas with expected costs and rental incomes for each of those uses to determine which will be the most profitable. This would also help to determine if the value of the land for a different use is greater than the value of the land under its current use.
Making the Right Assumptions
It’s important to understand which comparison properties are used when determining the value of a commercial property. Often, much older comps are used because there is a lack of direct comparisons. This makes the commercial market move slower in pricing than residential, as the comp property values take longer to catch up – so don’t be shocked if you see dramatic swings in the residential market that aren’t reflected in the commercial market.
Another consideration with your comparison properties is location. Even minor location differences can significantly affect the pricing and skew the valuation. An apartment building in the central downtown area of a city is very different from the same apartment building a few blocks south in the “sketchy” area. Or, with retail, being on a high-traffic road makes a huge difference in value when compared to an otherwise identical property a half-block off the main road. Often, these scenarios must be weighted based on the knowledge of the appraiser or realtor to appropriately compare the values.
One thing that is less telling of the value is the pro forma income. While it’s a helpful tool for certain valuation methods, it can’t provide a truly accurate value since it’s only an estimate. The rental rates, expenses, and costs of construction are very rarely exactly as predicted.
Finalizing Your Value
Once you have examined the different approaches to value for your subject property, it may be clear that they are all within a similar range. In those scenarios, we may average the figures together to find an appropriate number.
If one valuation method clearly is more appropriate and accurate for a property and aligns with the property’s highest and best use, we may simply use that figure alone.
Conclusion
For those looking to purchase a property, this information can help us to create attractive and competitive offers that still provide you with the fairest price. For those looking to sell one of their holdings, accurately determining the value positions your listing in a way that allows us to maximize your profits. No matter where you fall in the commercial real estate cycle, understanding the metrics involved in determining the value of a commercial property will help investors make informed decisions on how to approach pricing, as well as building and protecting your long-term value.
Our team’s priority is to maximize your property’s value both now and in the future. Call us today to start building your game plan for growth.
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