Commercial Property Valuation
3 Ways To Determine What A Property Is Worth
There are 3 ways to value commercial property:
- Cost Approach
- Sales Comparison Approach
- Income Approach
The Cost Approach (also called the Replacement Cost Approach) is the sum of the estimated vacant land and the depreciated replacement cost of the improvements (ie. buildings, parking lots, etc.) You will find that many people (even those who claim to know what they are talking about) misunderstand this calculation.
When using the Sales Comparison Approach (also called the Direct Comparison Approach) to value real estate, sales of similar properties are obtained and these sales are analyzed to develop various units of comparison. Pay careful attention to the section of that definition that says develop various units of comparison. When it comes to valuing commercial real estate, especially apartment buildings, you need to look more closely at comparables than just the total sales price.
Finally, we have the Income Approach (also called the Income Capitalization Approach). This is the most common approach used in commercial real estate valuation. The income approach to valuing real estate would not be used on residential properties. Valuation by the income approach consists of estimating a net operating income (NOI) for the property and converting this income to a capital value. The higher the NOI, the greater the value of the property.
Rents and expenses for the subject property are compared to similar properties. Expenses are stabilized as some expenses do not occur annually. The income (derived from a proforma income statement) is converted to a capital value by a ratio known as a capitalization rate or "cap rate" as it is commonly called. This rate is obtained from an analysis of sales of similar properties in the community or region where the subject property is located.
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In addition to the cap rate, there are other formulas and measures that can be employed to help determine the value of a property. Like the cap rate, they also utilize the cash flows of a property to determine value. A couple of examples are the Gross Rent Multiplier or GRM (also called the Gross Income Multiplier or GIM), and Discounted Cash Flow Analysis or DCF.
Although the above methods of valuation seem very "mathematical" in nature, in actual fact valuing commercial property is as much of an art as it is a science. You will understand what I mean once you delve into the valuation methods a little more in depth.
So why is it so important that you understand completely how to value commercial property before you begin investing in it? Can't you just hire people (real estate brokers, appraisers etc.) to figure that out for you? Well, yes and no. Keep in mind that no one will look out for your best interests more than you. Don't rely entirely on someone else's opinion. You will regret it.
I have argued with more than one real estate appraiser on more than one occasion about the valuation of a commercial property. (And I always got my way of course ;)) But the fact is, if I didn't have a strong knowledge and complete understanding of the valuation process, there is no way I could have argued my point convincingly. Of course there are more important reasons for understanding commercial property valuation than convincing an appraiser to see things your way. For instance, making sure you don't overpay for the property!
One of the biggest mistakes I see people make when starting out in commercial property investing is not making sure they understand as much as they can about the process (the entire process that is) before they jump in and purchase their first deal. On that note, the best thing I can recommend for you is the following...
Study some books and or courses on commercial investment. Go to your local library or search on amazon for relevant books. For a good course, I recommend one that is written by a colleague of mine. It is all about
how to buy your first apartment property
Once you have a solid foundation, then you can begin contacting commercial property agents and looking at deals.
But do your homework first.
On that note, let's take a look at a few things that will serve you well when determining the value of commercial investment real estate.
Don't Make This Income Property Valuation Mistake
Does Buying Investment Real Estate Below Replacement Cost Make It A Good Deal?
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