Many people who want to be involved in commercial real estate are confused about how to come up with the value of a property. I would like to take a few minutes to explain the three basic methods of valuation used in commercial real estate.
Comparable Sales Method
This method is used primarily in residential real estate and small investment properties such as single family dwellings to be flipped or rehabbed.
The basic premise behind the comparable sales method is to find other recently sold properties within a relatively close distance that are as similar to your “subject” property as possible. If you can find enough properties that are “comparable” that have sold recently, it is safe to assume that the value of your subject property is similar to the value of the other comparable properties.
The preferred criteria used by most residential investors and appraisers is to find comparable properties that are within the same neighborhood if possible or within 1 mile of the subject property that have the same number of bedrooms, same number of bathrooms, total square footage within 10%, same number of floors, and similar construction that have sold within the most recent 6 months.
If all of the criteria can’t be met, then adjustments are made to the values to come up with a reasonable value for the subject property.
This method is difficult to use in commercial properties due to the fact that there probably aren’t many comparable properties that have sold within a valid time frame or within a reasonable distance to make them valid comparisons.
Replacement Cost Method
Let’s imagine you have an office building that has caught your attention and you’re wanting to find out how much it is worth and what you should be willing to pay for it. The Replacement Cost Method will essentially tell you how much it will cost to build a brand new office building today with as similar construction and location costs as possible.
While this method is commonly recognized by industry professionals, it is actually quite complex to calculate. It is a very good idea to contact two to three very knowledgeable industry professionals who are familiar with the area and product type to obtain replacement cost estimates since costs vary dramatically in different areas.
A good rule of thumb is to be a buyer of real estate whenever prices drop below replacement cost, and be a builder of real estate whenever prices rise above replacement cost. Replacement cost is used as a baseline to determine the investment strategy and isn’t really a method used to determine the price one is willing to pay for the property.
The Capitalization Method is probably the most referred to method in commercial real estate. You will hear the term “Cap Rate” thrown around more times than you want to hear once you get involved in commercial real estate. I believe this valuation method is probably the most misunderstood method, but many real estate investors rely on the cap rate as their only form of valuation to determine their offer or sales price.
The basics of the capitalization method hinge on the income of the property and the cap rate converts this income into value. The Net Operating Income (NOI) is divided by the cap rate to determine the return on the invested capital.
In order to calculate the NOI, you must first figure out what the potential income for the property is. Then you subtract any vacancy or collection costs as well as any operating expenses to come up with the NOI. Once you know the NOI, you divide the NOI by the going cap rate to determine the value of the property.
How do you come up with the cap rate? The answer is there really isn’t an answer. Investors set their cap rate based on what they are willing to accept to risk that amount of money. Often times there isn’t enough market data to determine what the average cap rate should be.
If your cap rate is too high compared to what other investors are paying then you won’t win very many bids because your offer price will be lower than others. If your cap rate is lower than other investors you will win many bids, but most likely will end up paying too much for the property.
There are many fallacies to the capitalization method and this is debated in CRE circles around the country and globe. Unless the cash flow of a property changes drastically, it really doesn’t affect the value of a property that much, but a slight variance in the cap rate can have a very significant effect on the property’s value.
CCIM has a very good article that outlines some of the fallacies within cap rate calculations. You can read this article here.
So Now What?
Are you confused yet? How does this information help determine the price of a property. Basically what all of this information means is that you need to know how to use all of these methods working together when determining what an actual value of a property.
If you don’t have a very good understanding of the market and the value of properties, please seek out the help of a reputable commercial real estate professional in your area.
What questions do you have? Please let me know in the comments below.