Calculating the Value of Commercial Real Estate Properties

Commercial real estate valuations are a process of estimating the value of a CRE property, usually for the purpose of buying, selling, financing, or tax assessments. A CRE valuation considers a variety of factors such as the location, condition, size, age, and income potential of the property, as well as market trends and other economic factors. Accurate valuations help CRE stakeholders make informed decisions about the value of the property, the risks and opportunities involved, and the appropriate pricing for buying, selling, or financing the property. Ultimately, valuations contain valuable information for stakeholders helping ensure fair and transparent transactions. It’s important to work with qualified appraisers such as our valuation experts at AEI who have the expertise and experience to provide accurate and reliable valuations that reflect market trends and conditions.

When it comes to commercial real estate valuations, understanding the three common approaches – the income approach, sales comparison approach, and cost approach – is crucial for making informed decisions. Before diving deep into the different approaches let’s review key terminology and concepts in relation to commercial real estate valuations—our valuation experts can also help explain these concepts and apply them to your specific property or investment.

Key CRE Valuation Terminology

Market Value: The most probable price that a property would sell for in an open and competitive market, assuming that both the buyer and seller are knowledgeable and willing to transact. Market value takes into account the property’s physical, legal, and economic characteristics, as well as the prevailing market conditions.
Price: The amount of money that a buyer pays for a property. Price can be influenced by many factors, including supply and demand, financing terms, and negotiations between the buyer and seller.
Capitalization rate (cap rate): The cap rate is the rate of return that an investor expects to earn on a property. It is calculated by dividing the net operating income (NOI) by the property’s value.
Net operating income (NOI): The NOI is the income that a property generates after subtracting all operating expenses, but before subtracting debt service and income taxes.
Location: The location of a property is often one of the most important factors in determining its value. Properties that are in desirable neighborhoods or areas with high demand may have higher valuations than properties in less desirable locations.
Age and condition: The age and condition of a property can also impact its value. Older properties or those that require significant repairs or renovations may have lower valuations than newer, well-maintained properties.
Supply and demand: The supply and demand for commercial real estate in a particular market can impact valuations. Properties in markets with high demand and low supply may have higher valuations, while those in markets with low demand and high supply may have lower valuations.
Zoning and land use restrictions: Zoning laws and land use restrictions can impact the value of a property by limiting the types of uses allowed or by restricting the size or configuration of the property.

The Cost Approach Explained:

The Cost Approach Cheat-sheet

The cost approach is based on the principle of substitution, which states that a buyer will not pay more for a property than the cost of constructing a similar property with the same utility. Essentially the cost approach determines the value of a property by estimating the cost to replace it with a similar one, taking into account depreciation, land value and other factors. The process involves three main steps:

Estimate the cost of constructing a new property: This involves determining the current cost of labor and materials, as well as any other expenses required to build a similar property.
Adjust for depreciation: Depreciation refers to the loss of value due to wear and tear, obsolescence, and other factors. Your appraiser will estimate the amount of depreciation and subtract it from the estimated cost of a new property. Depreciation is typically calculated using one of three methods: Physical deterioration – the decrease in value of the property due to wear and tear, such as damage to the roof, walls, or foundation. Functional obsolescence – the decrease in value of the property due to functional issues, such as an outdated floor plan or insufficient parking. External obsolescence – the decrease in value of the property due to external factors, such as changes in the surrounding area, economic conditions, or zoning restrictions.
Estimate the land value: Your appraiser will estimate the value of the land on which the property is located, based on comparable sales and other factors. The final value of the property is determined by adding the estimated land value to the adjusted cost of the building.

When is the Cost Approach Used?

The cost approach is most commonly used for new or recently constructed commercial properties, particularly those that do not have significant income histories or sales data available. This includes specialty properties such as churches, schools, and government buildings, as well as other properties that are not typically bought or sold on the open market.

The cost approach can also be useful in situations where the income approach or sales comparison approach are not appropriate. For example, if a property has unique characteristics that make it difficult to find comparable sales, or if the income potential of a property is uncertain, the cost approach may be the most reliable method for determining its value. The cost approach can also be used to check on the value derived from other approaches, such as the income approach or the sales comparison approach.

Important Reminders When Using the Cost Approach

Use approach in conjunction with others: While the cost approach can be useful for new or recently constructed properties, it has some limitations. Therefore, your appraiser may use one or more of the other approaches in conjunction with the cost approach to arrive at a more reliable valuation.
May not reflect older property value accurately: The cost approach may not accurately reflect the value of older properties, as it does not consider the effects of market forces on property values. Older properties may have unique characteristics or historical significance that cannot be replicated through new construction.
Does not account for income potential: This approach also does not account for the income potential of a property, which can be a significant factor in determining its value. If a property has a high income potential, the value may be higher than what the cost approach suggests.
May not reflect unique property characterisitcs: Using this approach may not accurately reflect the unique characteristics of a property, such as its location, layout, or design. The cost approach assumes that a buyer will pay no more for a property than the cost to build a similar property, but unique characteristics can add value that is not reflected in the cost of construction.
Requires accurate depreciation estimates: The cost approach requires accurate estimates of depreciation, which can be challenging, especially for older properties.

The Income Approach Explained:

The Income Approach Cheat-Sheet

The income approach estimates a property’s value based on its income-generating potential. This approach estimates the present value of the future cash flows that the property is expected to generate over its economic life. The income approach is commonly used to value income-producing properties such as: apartment buildings, office buildings, shopping centers, industrial properties, and hotels/resorts. An appraiser will typically use one of two methods to calculate the value of the property under this approach:

Capitalization: This method involves dividing the property’s net operating income (NOI) by the capitalization rate to arrive at an estimated value. The capitalization rate is a ratio that represents the expected rate of return on the investment. It is typically based on the risk associated with the property, as well as current market conditions.
Discounted cash flow (DCF) analysis: This method involves projecting the property’s future cash flows over a certain period, usually 5 to 10 years, and then discounting those cash flows to their present value using a discount rate. The discount rate reflects the time value of money, as well as the risk associated with the investment.

Common Steps Involved in the Income Approach

The income approach involves the following steps but can vary depending on the method used:

Estimating the property’s potential income: An appraiser estimates the property’s potential income based on market rents and occupancy rates for similar properties in the area.
Subtracting operating expenses: The appraiser then subtracts the property’s operating expenses, such as property taxes, insurance, maintenance costs, and property management fees.
Determining net operating income (NOI): The difference between the property’s potential income and operating expenses is the net operating income (NOI).
Applying a capitalization rate: The appraiser then applies a capitalization rate (cap rate) to the property’s NOI. The cap rate is a percentage that reflects the property’s risk and return. The higher the risk, the higher the cap rate.
Calculating the property’s value: The value of the property is calculated by dividing the property’s NOI by the cap rate.

Essential Formulas Used in the Income Approach:

Net Operating Income (NOI) = Potential Income – Operating Expenses
Capitalization Rate (Cap Rate) = Net Operating Income / Property Value
Value = Net Operating Income / Capitalization Rate

Important Reminders When Using the Income Approach

Limited applicability to non-income producing properties: The income approach is most appropriate for properties with stable income streams and long-term leases, as these provide a reliable basis for estimating future income.
Sensitivity to changes in income and expenses: The income approach assumes that a property’s value is directly proportional to its income potential. Therefore, any changes in income or operating expenses can have a significant impact on the property’s value.
Does not account for future changes: The income approach does not account for future changes in market conditions, rent increases, or other factors that can affect the property’s income potential.
Limited usefulness for unique properties: The income approach may not be useful for unique or one-of-a-kind properties that do not have a lot of comparable sales or rental data.

The Sales Comparison Approach Explained:

The Sales Approach Cheat-Sheet

The sales comparison approach is one of the most common methods used to appraise commercial real estate. It involves comparing the subject property to similar properties in the same market that have recently sold, with adjustments made for any differences between the subject property and the comparables. In general, the sales comparison approach is most effective for commercial properties that have a lot of sales data available in the local market, and where the properties are relatively similar in terms of location, size, and condition. Retail centers, office buildings, and multifamily properties are some examples of commercial properties that may benefit from this approach.

Common Steps When Using the Sales Comparison Approach

Identify the subject property: Your appraiser will start by identifying the property being appraised and gathering information about its location, size, and condition.
Identify comparable properties: Recent sales of properties that are similar to the subject property in terms of location, size, and condition are identified. These are often referred to as “comparables” or “comps.”
Analyze the comparable sales data: The data on the comparable sales is analyzed–looking for similarities and differences between the subject property and the comparables.
Make adjustments: Adjustments to the comparable sales data are made to account for any differences between the subject property and the comparables. These adjustments may be based on factors such as location, size, condition, amenities, and other factors that can affect the value of the property.
Finalize the appraisal report: The market value for the property is determined through data analysis and a final report is finalized.

Essential Formulas Used in the Sales Comparison Approach:

Adjusted sales price of comparables = Sales price of comparables +/− Adjustments
Price per square foot = Sales price / Property size
Price per unit = Sales price / Number of units

Important Reminders When Using the Sales Comparison Approach

Limited data: In some markets, there may be limited sales data available for comparable properties, which can make it difficult to accurately estimate the value of the subject property.
Differences in properties: It can be challenging to find truly comparable properties that are similar in terms of location, size, and condition to the subject property. Adjustments must be made for any differences between the properties, but this process is subjective and can lead to inaccuracies.
Timing of sales: Sales data may not reflect current market conditions, as there can be a lag between when a property is sold and when the sale is recorded. This can make it challenging to accurately estimate the value of the subject property.
Inflation or deflation: Sales prices of comparable properties may not reflect current market conditions if there has been a significant inflation or deflation in property values since the comparable properties were sold.
Neighborhood boundaries: Neighborhood boundaries can impact the comparability of properties, as different neighborhoods can have different values.
Condition of comparables: The condition of the comparables at the time of sale may not be the same as the condition of the subject property, which can lead to inaccuracies in the valuation.

CRE Valuation Applications:

Valuation Applications Cheat-Sheet

Lending: Financial institutions require commercial real estate valuations to determine the appropriate loan amount for a property. Valuations help lenders assess the risks associated with a loan and ensure that the property value serves as adequate collateral.
Investing: As an investor, accurate property valuations are essential for identifying investment opportunities, forecasting potential returns, and managing risk. By understanding the value of a property, you can make informed decisions on acquisitions, dispositions, and portfolio management.
Taxes: Tax authorities rely on commercial real estate valuations to determine property taxes. A valuation report can help you understand your tax liability and provide the necessary documentation in case of tax disputes or appeals.
Right of Way: In cases where a public or private entity needs access to your property for infrastructure projects, such as roads or utilities, a commercial real estate valuation is crucial to determine fair compensation for the property owner.
Disputes: Valuations are vital in resolving disputes involving property value, such as a partnership dissolution. A thorough and impartial valuation can help parties reach a fair settlement and avoid lengthy and costly legal battles.
Advisory: Commercial real estate valuations can also serve as a valuable tool for strategic decision-making. Property owners and investors may seek a valuation for estate planning, merger and acquisition activities, or to determine the best use of their real estate assets.

Valuation Frequently Asked Questions:

Why do I need a CRE valuation? – A CRE valuation is important for investors, owners, lenders, and other stakeholders in the industry because it provides valuable information about the value of a property, the risks and opportunities involved, and the appropriate pricing for buying, selling, or financing the property.
How do I choose the right approach for my property? – The choice of approach depends on the specific property and market conditions. An experienced appraiser can help you determine the most appropriate approach for your property.
How long does a CRE valuation take? – The timeframe for a CRE valuation can vary depending on the complexity of the property and market conditions. Typically, a valuation can take anywhere from a few days to several weeks to complete.
What qualifications should I look for in a CRE appraiser? When choosing a CRE appraiser, it’s important to look for someone with relevant experience, industry knowledge, and professional certifications, such as the MAI designation and state certifications.

Final Thoughts:

When it comes to buying, selling, or financing a commercial real estate property, having an accurate and reliable valuation is crucial. That’s where a qualified appraiser like AEI comes in. With a team of experts who have extensive knowledge and experience in appraising commercial properties, AEI offers numerous benefits to stakeholders involved in commercial real estate transactions including:

Accurate valuations: Working with a qualified appraiser such as AEI can help ensure that the valuation of your commercial real estate property is accurate and reliable, taking into account a variety of factors such as market trends, property condition, and income potential.
Unbiased perspective: A professional appraiser offers an objective and unbiased perspective on the value of your property, helping you make informed decisions based on reliable data.
Compliance with industry standards: We follow a systematic process to ensure consistency and compliance with industry standards, such as those set by the Appraisal Institute, the Uniform Standards of Professional Appraisal Practice (USPAP), and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).
Use of modern technology: Our AEI valuation experts use modern technology to gather and analyze data, which can improve the accuracy and efficiency of the appraisal process.
Nationwide resources and reach: We have a team of professionals with MAI designations and state certifications, providing a nationwide reach and extensive knowledge of local markets.
Expertise in complex properties: AEI has experience in appraising a wide range of complex commercial properties, such as hotels, hospitals, shopping centers, and industrial facilities.
Assistance in decision-making: Our finalized reports provide valuable insights into the value of your property and the factors that affect it, helping you make informed decisions about buying, selling, or financing the property.

Overall, working with a qualified appraiser provides numerous benefits since the three common valuation approaches each have their strengths and limitations. If you’re in need of reliable and accurate valuations for your commercial real estate properties, AEI’s team of experts can help. With a nationwide reach, modern technology platform, and systematic processes to ensure consistency and compliance, AEI can provide you with the information and insights you need to make informed decisions about your investments. Contact us today to learn more about our valuation services and how we can help you achieve your commercial real estate goals.

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