How to Value Commercial Real Estate: Unveiling Key Valuation Methods

You can’t successfully make a profit if you don't know the value of the entity you want to buy or sell. While it's easy to do with a car or an old computer, it gets a little more tricky with properties especially in the commercial real estate industry. To achieve the maximum profit from a real estate sale or purchase, you need to accurately evaluate your holdings or potential acquisition properties before applying for a commercial real estate loan. While commercial real estate valuation is an art as much as it is a science, it is possible to learn.  

Key Points:

• How will I identify profitable properties to rent, acquire, or resell?
• What methods should I use to help me value my commercial real estate?
• How will I decide if I should include a certain property in my portfolio? 
• Can effectively valuing a property help me increase my profits from commercial real estate?

How to Value Commercial Real Estate: 8 Methods to Try

Here are some practical methods you can use to create commercial real estate valuations:

1. Market or Sales Comparison Approach

The market or sales comparison approach relies on a thorough analysis of the recent sales for comparable properties. The method involves looking for recently sold similar buildings within the same market to estimate a fair market value of the property in question.

For example, you can compare a duplex building with a similar one that sold in the same neighborhood one month earlier. However, the market approach has one significant drawback: finding appropriate comparables for commercial properties can be difficult. This property valuation method is used mostly to value residential real estate.

2. Replacement Cost Approach

With the cost approach valuation method, you look at the cost of rebuilding the property from scratch. As such, you consider the current value of the land and construction materials and other associated costs.

The cost approach is often used when it is difficult to find comparables - for example, if the property comes with specialized or unique improvements.

3. Income Capitalization Approach

This commercial property valuation method considers the potential income that one can earn from the investment property in question. You can estimate the projected income in a few ways - for instance, you could look at the income produced by similar properties.

For example, if you have purchased a building for $1 million with an expected yield of 5%, you can expect to earn $50,000 per year. Then, you should discount this expected future income to reflect the present value of the building

4. Cost per Rentable Square Foot Approach

Unlike usable square footage, rentable footage includes both the usable areas (where the tenants live) and the general areas (like elevators and stairways). With this approach, you would calculate the cost per rentable square foot, compare it with the average market cost per square foot, and finally estimate the property value.

A building has 10,000 rentable square feet, and the average annual rental cost is $12 per square foot. In this example, if the purchase price of the building is $1.7 million, you can expect to earn a 7% gross rental yield.

5. Value per Gross Rent Multiplier

This property valuation approach involves dividing the property price by its gross income.  Realtors mostly use this method to find properties that have an attractive price compared to the potential income they can produce.

For example, if you buy a commercial building for $500,000 and generate $70,000 in gross income per year, the building’s Gross Rent Multiplier would be $500,000 / $70,000 or 7.14. This is one valuation approach to consider when deciding how to invest in commercial real estate.

6. Value Per Door

This method to value commercial real estate is most often used for apartment buildings, as it estimates the value of the entire structure based on the number of units it contains.

For example, a 20-apartment building priced at $4 million would be valued at $2,000 / 20 = $200,000 “per door”. 

7. Hypothetical Development Approach

The hypothetical development method is used to value land subdivisions and development sites. With this method, the value of the land to the developer is determined as:

1. Net realization = gross total sales of the finished project - selling expenses (plus HST)

2. Total capital outlay (land, development, and interest costs) = net realization - margin for developer’s profit and risk

3.  Value of land and interest = total capital outlay - development costs, charges, and interests

4. Total land value = vale of land and interest - interest on land value

The final total land value will indicate whether the hypothetical development will be feasible or not.

8. Capital Asset Pricing Model (CAPM) Approach

The CAPM method has been used more extensively to value commercial real estate in recent years. The CAPM approach is based on assigning “beta” - a variable representing the relationship between the asset’s risk-adjusted returns and those of the market.

When applied to real estate, and deciding how to buy commercial real estate, you can use the return on an income-producing commercial property to calculate its value by choosing a beta that relates the property to other assets on the market.

Principles of Commercial Real Estate Valuation

Here are some important principles you should understand when looking at different types of real estate investment and valuing commercial real estate:

1. Utility

Utility describes the property's ability to meet the needs and requests of the potential owner. This approach can include using the property as your primary residence or generating rental income.

2. Demand

Demand refers to the current needs or desires for ownership and the corresponding financial ability to purchase the given commercial real estate asset.

3. Scarcity

Commercial properties aren't infinite, meaning that the building price will be affected by the abundance or scarcity of a specific area's distinctive property type.

4. Transferability

Transferability describes the ease of transferring the ownership of the property in question. For example, a large industrial facility with multiple owners or unpaid liens will be more difficult to transfer than a property with a single owner and no liens.

Real Estate Appraisal Terms to Know

Here are the most common terms related to real estate appraisal: