How to Value Commercial Property for Maximum Returns

Key Takeaways

• Investors generally calculate such values to garner a purchase price, gauge prospective value-add offerings, and determine whether a property is a solid strategic fit.

• As part of the underwriting process, lenders typically employ a commercial property value estimator to determine a borrower’s down payment, term length, and sometimes other provisions.

• The four primary factors that impact commercial real estate valuation are utility, scarcity, purchasing power, and desire.      

It is essential that investors in the commercial property space know how to value commercial real estate (CRE) for maximum returns, since an accurate valuation can help identify overlooked deals and avoid taking positions in overpriced real estate. Here is how to determine commercial property value, and more.

Understanding Commercial Property Valuation

Determining the fair market value of commercial property is of vital importance to investors and lenders alike, who can do so themselves or have a professional handle it.

Investors generally calculate such values to garner a purchase price, gauge prospective value-add offerings, and determine whether a property is a solid strategic fit.

As part of the underwriting process, lenders typically employ a commercial property value estimator to ultimately determine a borrower’s down payment, term length, and sometimes other provisions.

Note that a property’s cost does not equate to its value, as “value” is the relationship between the desired real estate and the promise it represents to its owner. In general, there are four primary factors that impact CRE valuation, and which must complement each other: utility, scarcity, purchasing power, and desire.      

Methods for Commercial Property Valuation

There are multiple methods for valuing commercial properties, each one providing insight into the property’s worth.

• Cost approach. This approach is frequently employed for special-use property or when it is hard to find comparable sales data. It focuses on the cost of building upon the property from the ground up, including materials, construction expenses, and the land’s current value.
• Sales comparison. This method, also called the market approach, depends for its valuation on recent sales of similar real estate in the same general market. 
• Income capitalization. This approach uses the net operating income (NOI) a property produces to determine the property value as compared with similar properties in a like market. 

How to Calculate Commercial Property Value

If one is using the income capitalization method, for example, say office buildings in Austin are trading at a 7.9% capital rate and a similar structure is producing an NOI of $500,000 annually. This approach would value the building at $6,329,114 ($500,000 NOI/7.9%).

Note that a property’s NOI is calculated by adding up all revenue then subtracting operating expenses. The cap rate is calculated by dividing a property’s NOI by the current market value. 

How IRR and CAGR Can Help

The metric internal rate of return (IRR) is utilized to assess capital budgeting projects and to evaluate property over time. In other words, it is commonly used by investors to gauge profitability.

In commercial property valuations, the IRR can supplement cap rates since the tool factors in sale proceeds and NOI for multiple years. It can also permit investors to compare opportunities.

Then there is the compound annual growth rate (CAGR), which is used to gauge the rate of return for an investment over a protracted time period. It is another metric that can be used on a complimentary basis in commercial property valuation. 

Commercial Property Appraisal

While a commercial real estate appraisal can be viewed as a pricing guide sans legal standing, a valuation establishes definitive value that can be used legally.

Depending on the property’s size and the information to be collected, commercial real estate appraisals can take weeks or months to finish. In general, steps include stating the appraisal report’s purpose, outlining the scope of work, collecting, and analyzing data, and calculating the property value. All the appraisal information is used to determine the property valuation.

In turn, the buyer uses the valuation to see what their property is worth in the current market.

Commercial Property Values

These elements have an impact on the value of a commercial property: 

• Location. All other things being equal, the better the location, the greater the real estate’s value per square foot. 
• Size. Structures that are smaller tend to sell for a higher per-square-foot price, a trend that is consistent among various property types.
• Condition. A property’s physical condition plays a key role in fixing its value. Well-maintained properties tend to command higher prices.
• Income potential. Income potential is a top factor in determining a commercial property’s value.
• Market environment. This external factor may have an impact on the property’s value.
• Economic trends. Other external factors to consider regarding commercial property valuations include inflation and industry-specific considerations.
• Legal considerations. There must be complete knowledge of all legal aspects concerning the property of interest before completing a valuation.

How to Estimate Commercial Property Value

Methods used in estimations include:

• Replacement cost. This refers to the amount it would take to rebuild a similar building using current prices, which some investors use to inform valuations.
• Gross rent multiplier (GRM). This is a relatively easy way in which an investor can compare one property to another and winnow candidates down. The method calls for dividing a property’s purchase price by its gross annual rent. All other things being equal, the lower a property’s GRM, the more possible potential it has. 

How to Look Up Commercial Property Value

There are a few ways to look up a commercial property’s value, but a few of the most used options include:

• Reonomy. Focusing on commercial property data and analytics, this platform offers information on property ownership, sales history, and loans.
• Xceligent. This platform provides information such as lease and sales data, market trends, and property details.
• Real Capital Analytics. This source offers information on debt financing and property sales.
• CoStar. A commercial property information and marketing platform, CoStar provides detailed information such as sales and lease data, market trends, and property data.
• Costar Commercial Exchange. With this digital marketplace, users can hunt for properties, compare prices, and link up with brokers.

There are also several tools available to commercial property investors including online databases, local assessors’ offices, and real estate agents and appraisers.

The number of search options is growing along with the popularity of real estate investing in general, and commercial properties in particular, as investors seek to steer away from volatility and toward asset classes that are not directly correlated with public markets. 

Intermingling such investments with the stocks and bonds in one’s portfolio also serves to mitigate overall risk, since spreading investments across varying assets means holdings are less likely to be wiped out due to a single negative event. Thus, diversification is an essential part of successful investing.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

While it is essential that investors in commercial properties understand the importance of real estate valuation, they should also know that the exercises required are complex and require research, the application of multiple methods, and consideration of several factors.