How Does Commercial Real Estate Valuation Work?

Commercial real estate questions? Here are some important things to know.

Commercial real estate valuation can be a tricky task. Whether you’re looking to buy or sell a commercial property, refinance a property, or revalue it for taxation purposes, an accurate valuation is important. But how do you put a value on complex commercial assets like office towers, hospitals, and industrial warehouses? In this article, we explore the question, “How does commercial real estate valuation work?”

bottom-up view of Park Tower in Tampa

 

If you buy a downtown office tower, you don’t want to overpay for it. If you were selling that same downtown property, you definitely want to be paid a fair price for it. Furthermore, if your job is leasing properties and setting the rents, you want to make sure the owner gets the full value from her investment.

So how do you arrive at an appropriate value for a commercial property? Below, we review some common terms, identify a few guiding principles, and review various approaches to valuation. But first, let’s take a look at the most commonly used concept, the discounted cash flow, that drives overall valuation principles.

Discounted Cash Flow

The most accepted approach to commercial real estate valuation is the discounted cash flow (DCF). A sponsor will project between five and ten years of cash flows based on her pro forma, market knowledge, and real estate experience. Those cash flows are then discounted backwards to today’s dollars and added together to arrive at net present value (NPV). She must choose a discount rate that (at a minimum) approximates her weighted average cost of capital, including debt and equity. This valuation technique often incorporates the income capitalization approach while always taking into account the time value of money.

Consider a property that is expected to earn $100,000 per year in NOI (net operating income) for five years and can achieve a weighted average cost of capital of 10%.

 Year 1Year 2Year 3Year 4Year 5
NOI$100,000$100,000$100,000$100,000$100,000
Discount Factor(1+10%)(1+10%)^2(1+10%)^3(1+10%)^4(1+10%)^5
NPV$90,909$82,645$75,131$68,301$62,092

The sum of the above net present values is $379,079, which is the value you as an investor would be willing to pay today if her cost of capital equaled 10%. In addition, most DCFs assume a sale at the end of the hold period and use a projected cap rate to estimate a sale price. That sale price is then discounted backwards in the same way as the property cash flows and is added to the NPV calculation.

Why Does Property Valuation Matter?

Property valuation matters for several reasons. No one wants to lose their shirt in a commercial real estate deal. Sellers want the best price on the transaction and buyers don’t want to overpay.

On top of that, tenant leases and monthly rents have a direct impact on a property’s value. Failing to command rents that are similar to comparable properties could lead to an undervaluation of your property. After all, property owners cannot easily sell their building based on projected rents, particularly in the rarified commercial real estate world of institutional caliber office buildings. From this perspective, property valuation matters immensely and by using one or a combination of the valuation approaches below, you can correctly determine a commercial property’s current value.

Real Estate Valuation Terms to Know

When talking about real estate valuation, there are a few key terms that you need to be familiar with:

  • Cap Rate – The property’s net annual rental income divided by its current value. In general, Cap Rate provides the property’s expected rate of return. Yet it doesn’t take financing or below-market rents into account, nor does it reflect returns on investment over time.
  • Debt Service – Monthly or yearly payment which generally includes interest and principal repayment.
  • Gross rent multiplier (GRM) – The property’s sales price divided by its annual gross potential rent. In contrast to Cap Rate, GRM doesn’t include expenses so it is far more of a blunt instrument in property valuation.
  • Net Operating Income (NOI) – The property’s rental income minus operating expenses.
  • Price Per Square Foot – The purchase price, or total cost of developing a project divided by square footage. This figure doesn’t include the unit types, number of units, the property’s income, or its physical condition.
  • Return on Investment (ROI) – Cash flow after debt service divided by the total equity investment.
  • Value – The estimated selling price for an investment property in the open market based on the current value of its projected income stream or one of the other valuation techniques discussed below.

Related: Commercial Real Estate Jargon Explained

Principles Guiding Valuation

In commercial real estate investment, value hinges on a property’s economic benefit to its owner; the real value of commercial properties comes from their income production and tax advantages. For instance, an apartment building brings very little personal enjoyment for the owner. However, the owner benefits from income derived from tenant rents and depreciation of the building. Below are a few principles that guide the valuation process.

sign for Castille at Carillon office/professional complex

Principle 1: Utility

Utility concerns how well a property can meet the current or next owners’ needs. This is largely driven by an owner’s investment strategy. A building that requires some upgrades in order to maximize rents and reach full occupancy will be of greater utility to a value-add investor willing to take on risk than it will be to an institutional investor looking for a steady yield.  That risk-averse institutional investor will derive greater utility from a building that is well located, has little or no deferred maintenance issues, and is fully occupied with high credit tenants.

Principle 2: Demand

Demand is a measure of the number of people or entities active in a market looking to acquire a certain type of asset. Those people and entities must have the wherewithal to close on a transaction. In the downtown office building world, that population is small relative to, for example, a value-add multi-family housing project. That said, the available supply of downtown office buildings is also limited, so when good opportunities arise, demand can still lead to a competitive environment.

Principle 3: Scarcity

The flip side to demand is availability of product on the market. There will always be a finite supply of competing properties. This is what we call scarcity, yet even with large scale office buildings, scarcity can very quickly turn to oversupply. There are two primary ways this can happen.  One is as demand overwhelms supply and rents increase, older buildings, previously uneconomical to upgrade and improve, may become viable investments. The other way scarcity can decline is when supply increases due to new construction.  This is less common as it is more costly to build new office buildings, riskier, and takes at least three years in most downtown environments. The risk of oversupply is very real with development, especially considering new office construction tends to occur in waves. Conversely, it is rare for office space to be removed from a market, but it does occasionally happen.

Principle 4: Transferability

Transferability refers to how easy it is to transfer ownership rights of a commercial property from one party to another. There are many features that dictate the ease with which a building can be transferred from one owner to another and they are generally similar no matter what that nature of the real property.  For example, selling a single-family home involves a marketing period, a negotiation period between prospective buyer and seller, an inspection period, then financing, title insurance, and close.

In principle these phases of a single-family home transfer are no different from the phases involved in transferring a downtown skyrise office building except for one major (obvious) variant: scale. The sheer size of an office building transfer creates considerable transfer friction relative to a single-family home transaction.  All phases of the transfer take longer, are far more complex and are considerably more costly. And while the sale and transfer of a single-family home has become largely commoditized (you can do it now with a click of a button online in some cases), transferring an office building to a new owner requires a raft of highly skilled professional experts to weigh in.

Looking to turn some commercial property around? Contact Feldman Equities today!

Principle 5: Cost Versus Price Versus Market Value

Cost, price, and market value are often used interchangeably which can cause some confusion when looking at an investment opportunity. Cost is how much a developer spends on labor, materials, land, and other things to construct the property. In theory, the ‘cost’ of a building should always be less than the true value of a building – there is little point, for example, spending money on a project only to find that the ultimate value of the building equals the cost i.e. that there is no profit or gain to reward the effort and risk incurred.

Price is what a buyer pays for a property, though, depending on the buyer’s investment strategy, there may remain additional costs to yield the maximum value for the building. For example, a buyer might pay $20 million for a building with the expectation that it is going to invest another $2 million in improvements to fill vacancies and increase rents in order to maximize the value of the building.

The most important factor driving valuation of a building is income – how much income does a building currently generate for its owner and the potential for income to increase over time – are the core drivers in building valuation. Combining these various different approaches to building valuation – cost, price, and income – provide different perspectives of valuation that are used in conjunction with each other to value a building. These different valuation approaches are used to make investment decisions and also by lenders in determining how much to lend to a project.

business plaza with Morgan Stanley tower in background

Approaches to Commercial Real Estate Valuation

Sponsors will typically look holistically at the combination of the purchase price of a building together with the cost to maximize rents and solve for a required return hurdle. This calculation is, however, almost always dependent on how much debt the sponsor can raise for a project.  Lenders (banks) also apply valuation methodologies but theirs are often driven by regulations rather than strictly by the profit motive and so their approach is somewhat different.

Lenders need to know how much a building is or will be worth and will determine that worth based on location, total cost expended over a specific time period, and in comparison to similar properties. Lenders’ valuation methodology is almost always more conservative than a sponsor’s, so sponsors should factor that into their financial planning.

While lenders and sponsors are attempting to arrive at the valuation of a property, their methodology for reaching a predicted value is different because their goals are different. With this in mind, here are some common approaches to commercial real estate valuation used by both lenders and sponsors.

Cost Approach

How much would it cost to rebuild a property? That’s the main question in this approach. Basically, this valuation method adds up the various costs—labor, materials, land, etc.—to determine a property’s value. This is also known as replacement cost. The cost approach is useful if a property doesn’t have enough comps. For example, if you were buying an old school building, you might use the cost approach. The reason is that those types of properties don’t sell very often.

An appraiser might use the cost per square foot, the unit-in-place method, or the quantity-survey method to determine value. Regardless of the specific calculation, the main idea is to value a property based on the cost to rebuild it.

Related: Building Classifications

Income Capitalization Approach

In contrast to the cost approach, this method focuses on the property’s income-generating potential. We can only use it for income-producing properties like retail centers, multifamily housing, office buildings, and other properties. You could not, for example, use this approach to value your primary residence. In order to value an income-producing property, you first need to know its NOI (net operating income). A simple NOI formula is:

NOI = Gross Income – Operating Expenses

Depending on the specific property, this can be a complex calculation. All real estate investors use a Pro Forma which gives a detailed explanation of both expenses and income to calculate NOI. Cap rates can be determined if you have the value and NOI of comparable properties. Alternatively, brokerages regularly report on cap rates down to the submarket and asset type. Once you know the NOI and cap rate, you can use this formula to calculate value:

NOI / Cap Rate = Current Property Value

Alternatively, you can find cap rate by dividing the property’s net annual income by its current value:

NOI / Current Property Value = Cap Rate

 

Related: What is a Good Cap Rate?

Sales Comparison

If you’re leasing an office building, you need to know the value and sales prices of other nearby office buildings. To do this, you use the Sales Comparison method. Some people refer to this approach as the Market Method or Market Approach. This method uses prices from recently sold comparables (comps) to determine a property’s value.

In general, this approach determines valuation with an apples-to-apples method. It compares things like square footage, amenities, location, land value, etc. in both current listings and recent sales to arrive at a property value. If otherwise comparable properties have some differences, adjustments can be made based on the approximate value of those differences. In residential home sales, for example, a home with a pool that is otherwise comparable to the neighbor’s house which recently sold could be adjusted up by $25,000. This approach works best when there are enough recent sales for comparison.

Value Per Door

As the name implies, this valuation approach starts with the number of units to determine commercial real estate values. We find value per door with the following formula:

Sale Price / Number of Units = Value Per Door

For example, if you purchase an apartment complex with 20 units for $4,000,000, then the value per door is $200,000 ($4,000,000 / 20 units = $200,000 per unit). On the other hand, you can also use this approach to make value comparisons between different properties. This valuation approach works best when all the units are roughly the same size, type, and quality. Also, the owner should have similar costs for maintaining each unit.

Other Approaches

Many times, the valuation approach depends on the asset. For example, the Value Per Door probably won’t work as well for a commercial office high rise which has office suites of various sizes. Also, the Sales Comparison approach won’t work as well for unique properties like church buildings or schools. In some cases, only using one of these approaches gives you a skewed valuation.

At the same time, it’s possible to determine valuation by combining approaches for a more accurate valuation. Because of this, another reason to use more than one valuation approach is that each has both pros and cons.

Which Approach Is Right?

While there is no ‘right’ approach to commercial real estate valuation, each method does have its own pros and cons. The Sales Comparison approach works well when you have enough recent sales. Yet on the flip side, not having enough comps or not enough similar comps makes this approach difficult. This could happen in smaller markets or with assets that don’t sell very often. Another disadvantage of this method is its failure to factor in tenant vacancy, lost rents, unexpected repair costs, or other unplanned expenses.

In the event that you can’t find enough comps, the Cost Approach could work well for valuation. However, the Cost Approach also has its weaknesses. Mainly, it doesn’t factor in the property’s income as a part of valuation. Also, unlike the Sales Comparison approach, it doesn’t consider the selling price of comps.

If you can’t use the Sales Comparison or Cost approaches, the Income Approach is a good method. It helps you gauge the quality of a commercial real estate investment by showing the projected income it will produce over a number of years. Yet its accuracy depends largely on the property having predictable expenses and income. And like the Sales Comparison method, the Income Approach doesn’t factor in unforeseen future repairs, possible vacancy, or lost rent due to tenant delinquency. Yet as we saw above, you can even use a combination of any of these methods to more accurately value a property with the discounted cash flow being the most commonly used and the most reliable.

The Importance of Accurate Commercial Real Estate Valuation

Regarding commercial real estate, a property’s value is important for various reasons. For starters, valuation affects sale price. It also plays a key role in refinancing a property. Valuing a property accurately is the most important skill a real estate developer can have; it allows for maximum (prudent) leverage, maximizes returns for shareholders, and helps to identify acquisition opportunities in the market when buying from less sophisticated sponsors who may undervalue their own property.

Curious about your property’s value? Contact Feldman Equities today.

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