Valuating commercial real estate requires professionals with expertise to accurately value your property. Commercial properties differ in size, features, usability, and other factors, and appraisers use various methods to calculate their values.
Appraisers use the Cost, Income Capitalization, and Sales Comparison Approaches to evaluate commercial real estate. Each method uses a different step-by-step guide to calculate the property’s value while considering the land value, location, revenue, and other factors.
The most accurate appraisal value is vital to securing a loan, investing, or selling commercial real estate. Sourcing the expertise of a professional appraiser is crucial. Still, it is also wise to familiarize yourself with the various valuation methods and the step-by-step guide.
How To Value Commercial Real Estate
As an investor, you must avoid purchasing commercial real estate based on emotions or estimations. Valuation’s primary goal is to provide an accurate value to a property to prevent financial loss or overpaying for a property.
There are several valuation methods to accommodate the different types of commercial real estate, and each method considers various factors. You must understand the evaluation process and that it is best to acquire help from professionals to assist you. Generally, appraisersuse one of three methods to evaluate commercial real estate.
Let’s examine the three methods commonly used to evaluate commercial real estate.
Cost Approach
The cost evaluation method is a popular approach appraisers use to provide an accurate value to a commercial property. This approach relies on the cost to construct the building and considers the material, labor, and civil expenses to establish the value. The land is valued separately from the building, whereafter, the two totals are added together to provide an appraisal value.
The CostApproach is also used to update a commercial property’s appraised value when structures are added or improvements are made, affecting the overall value. The Cost Approach is often used to evaluate commercial properties like hospitals, churches, schools, and government buildings that do not generate an income and are rarely sold.
Cost Approach Methodology
Appraisers using the Cost Approach appraisal method consider various factors to get an accurate value of a commercial property. Here is a breakdown of the Cost Approach methodology:
- Land value – An appraiser will estimate the land value as if it were vacant and use the Sales Comparison Approach. This approach estimates the value reflecting the best use possibilities for the vacant land, considering that land does not depreciate.
- Construction estimate – The appraiser calculates the construction and improvement of the building, which includes material, labor, and civil costs.
- Depreciation – The appraiser considers deterioration factors like structural, roof, and paint damage, including economic and functionalobsolescence.
- Total appraisal value – The appraiser combines the calculated evaluation cost with the estimated land value to determine the total appraisal value.
Cost Approach formula:
Building replacement cost – depreciation cost + land value = Commercial real estate value
There are three cost estimation methods:
- Square-foot method – An appraiser takes the square-foot cost of a comparable and recently built building and multiplies the amount by the amount of square feet in the subject building.
- Unit-in-place method – The unit-in-place method separates the building into units like the roof and walls and values them separately, using the material and labor costs to construct each unit.
- Quantity-survey method – The quantity-survey method calculates using the raw material quantities and installation costs (labor) to construct the subject building.
Depreciation
When evaluating commercial real estate, appraisers consider the condition of the property and all the factors that adversely affect the value. Anything that adversely affects the value of the property depreciates the value. Here are some depreciation factors:
- Physical deterioration – The physical building is subject to various deterioration factors like paint, roof damage, structural problems, etc.
- Functional obsolescence – Design features like outdated appliances and dated-looking features often affect a property’s desirability and value.
- Economic obsolescence – The property’s location affects its appraisal value, like if it is near to polluting factories or an airport.
Income Capitalization Approach
An investor’s return and the property’s net income are considered when valuing a property using the Income CapitalizationApproach, commonly called the Income Approach. The Income Approach method is ideal for appraising shopping centers, office buildings, apartment complexes, and any other commercial property that provides a predictable and steady future income.
The Income Capitalization Approach is divided into Direct Capitalization and Gross Income Multipliers.
Direct Capitalization
The steps an appraiser will take when utilizing the Direct Capitalization approach are as follows:
- Gross income – The appraiser estimates the potential annual gross income of the commercial property.
- Collection losses – Losses from rent and vacant units affect the gross income, and the appraiser considers these collection losses.
- Operating costs – The appraiser must deduct operational costs to determine a yearly net operating income for commercial properties.
- Capitalization rate – The appraiser estimates the rate of return and the cost per unit for the class or kind of commercial property that the typical investor will pay.
- Property value – The appraiser applies the property’s yearly net operating income with the capitalization rate to produce an estimated property value.
Gross Income Multipliers
The Gross Income Multiplier (GIM) method calculates the selling price and the rental income to produce the market value of the commercial real estate. The gross annual income generated by a property is used to calculate its GIM, and the formula works as follows:
Rental Income ÷ Sales Price = Gross Income Multiplier
Using rental data and recent sales from a minimum of three properties comparable to the subject property helps the appraiser establish an exact GIM and determine the market value. The appraiser will take the calculated GIM and use the following formula to calculate the estimated market value of the subject property. This is how the market value is determined:
GIM x Rental Income = Estimated Market Value
Sales Comparison Approach
Appraisers frequently employ the Sales Comparison Approach, commonly referred to as the Market Data Approach, to calculate property values.
This method uses commercial real estate in the same area with similar characteristics, recently sold, to provide an estimated value to the subject property.
The properties with similar characteristics used to provide the estimated value are called “Comparable property.” For a comparable property to provide a valid valuation, it must:
- Share a close similarity to the subject property.
- Have been sold in an open, competitive market within the last year.
- Have been sold in normal market conditions.
To get a reasonably accurate valuation, the appraiser must use at least three, if possible, more essential characteristics that match the subject property. Here are the three essential comparable factors needed:
- The most important factor to consider is the property size.
- Equivalent features between the subject property and the comparable properties.
- The location of the comparable properties has a large impact on market value.
Comparables’ Qualities
It is almost impossible to find two exact properties, and appraisers must adjust the valuation for the dissimilar features and other factors affecting the value, which include:
- The condition and age of the buildings.
- The date when the comparable property was sold, especially if economic changes occurred between the appraisal date and the comparable property’s sale.
- The sales terms and conditions, if it resulted in the property being sold at a reduced price. For example, property sold because the seller was under duress or property sold at a discount price to a relative.
- The location influences the price because a property’s value differs in various areas.
- Physical features like the quality and type of construction, the lot size, the property’s square feet, etc.
The adjusted sales prices of the comparable property determine the valuation of the subject property. The comparable property with the least adjustments usually provides the most accurate valuation.
Conclusion
The three most used valuation methods for commercial real estate are the Cost Approach, Income Capitalization Approach, and Sales Comparison Approach. Each method produces the same result but uses a different method and step-by-step guide to calculate the property’s value.