Accurate property valuation is time-consuming but essential for informing profitable commercial real estate investment decisions. Two of the most common ways to estimate the value of a property are the rental income and market approaches. So, how do these methodologies compare?
The rental income approach assesses the value of commercial real estate (CRE) by analyzing the income it generates while the market approach derives property value from the prices of comparable properties. The rental income approach is optimal for CRE valuation and superior to the market method.
It is highly beneficial for CRE investors to know the fundamental principles and methods for determining property value. For those wanting to learn about the rental income and market approaches to property valuation in the context of CRE, it might be worthwhile perusing the following information and insights.
CRE Valuation: Rental Income Vs Market Approaches
Reliable and accurate property valuation is one of the most fundamental aspects of commercial real estate (CRE) investment.
There are numerous ways to assess the value of a piece of real estate, with the following two approaches among the most widely used:
- Rental income
- Market
These approaches differ in their analytical focus and suitability for property valuation in the CRE sector.
The market approach is a comparative method that derives real estate value from the market values and prices of similar properties in the surrounding area. Investors typically use this method to appraise the value of residential rather than commercial properties.
The rental income approach is the standard method for property valuation in the CRE sector. This analytical approach determines the value of a property based on how much income it generates. The rental income approach uses past and current financial information to estimate future returns on investment.
How To Value CRE: Market Approach vs. Rental Income Approach
Let us examine how the rental income and market approaches work and why the former method is superior for conducting CRE valuations.
The Market Approach
The market approach to real estate valuation is a comparative approach that derives the value of a property from the average market value of analogous properties in the area.
When using the market approach, investors survey the local CRE market to identify properties for sale (or recently sold) with comparable characteristics to the subject property. The kinds of characteristics to consider are:
- The location of real estate
- The building size and features
- The age and condition of the building
After identifying these properties, the next step in the CRE valuation procedure is to determine their average market value. This entails an analysis of:
- Sales prices (past and present)
- The ratio between supply and demand
- Market conditions (levels of current and projected growth)
Finally, this average figure is used to estimate the market value of the particular property under valuation.
Rental Income Approach
The rental income approach to real estate valuation assesses the value of a property based on the income it generates. When using this method, investors analyze the amount and quality (stability) of rental income to estimate the future earnings of the property. The aim is to evaluate whether the rental income provides a sufficient return on investment (ROI).
The rental income approach uses the following equation to calculate the estimated value of a property:
- Net operating income (NOI) from rents / capitalization rate = property value
Implementing the rental income approach entails gathering and interpreting information about operating efficiency, including factors such as:
- The condition of the plot and buildings
- Occupancy rates
- Rental leases (terms and payment amounts)
- Tenants (stability and quality/performance)
So, this valuation method requires detailed information about the NOI and capitalization of the real estate one is analyzing.
Net Operating Income (NOI)
In the CRE sector, net operating income (NOI) indicates the total income that a property generates from rental payments during a specific period (typically one year). This metric allows investors to estimate the future earnings and profits the real estate will yield.
The equation for calculating NOI is as follows:
- Effective gross income (EGI) – operating expenses over 12 months = NOI
Determining the NOI requires that investors identify the effective gross income (EGI). The EGI is a metric that indicates the expected cash flow of a property.
The EGI derives from the potential gross income (PGI), which involves the following formula:
- Number of rental units x annual rent (market rate) + additional income = PGI
Once you calculate the PGI, you can work out the EGI using this equation:
- PGI + other income – vacancy rates and credit losses = EGI
Capitalization Rate
The capitalization rate is central to real estate valuation and the rental income approach. This metric derives from the ratio between a property’s market value and rental income (typically for one year).
Here is the formula to calculate the cap rate:
- Annual NOI / present market value of the property = capitalization rate (%)
Is Rental Income Or Market Approach Best For CRE Valuation?
Real estate professionals agree that the rental income approach is more strategically advantageous than the market method for performing CRE valuation.
The first reason is that, unlike market-based analysis, the rental income approach reveals information about the quantity and quality of returns that a particular property yields (or is likely to yield). This information is critical for CRE investors, whose fundamental purpose is to generate income and profit from their investments.
When investors have reliable, accurate financial data about a property (such as operating income and expenses), the rental income approach is optimal for CRE valuation.
The second reason why the rental income approach is also more advantageous for CRE valuation than the market approach relates to the diversity of properties in the commercial sector.
Commercial properties tend to be more heterogeneous and idiosyncratic than residential real estate. This diversity means there may not be enough comparable commercial properties in the local area to implement the market approach.
The market approach is better suited for valuing residential properties, which are generally more homogeneous – and thus more readily comparable – than those in the CRE sector.
Conclusion
Conducting accurate property valuation is a fundamental aspect of successful real estate investment. Using the optimal method for the type of property under assessment is crucial. When determining the value of CRE, the rental income approach is more strategically advantageous than the market method.