Commercial Property Valuation Methods
How much is a commercial property worth? That’s the age-old question in real estate. Unfortunately, there’s no menu of prices that states all type A properties are “x” amount of dollars or type B properties are “y” amount of dollars. There’s no crystal ball that can guarantee how much a property will bring. Do real estate agents, brokers and appraisers stick their finger in the air to see which way pricing is going and guess? Some might say yes when a property is obviously over or under valued, but there really are tried and true methods to commercial property valuation. Although market conditions and supply and demand do play a part in how much a property ultimately sells for, the starting point for commercial property value is based on three methods – market comparables, cost replacement and income approach.
Although mostly used for land and residential property, the market approach is also used for commercial property. This approach compares a property to the same type and class of properties, called comparables, sold within the prevailing twelve months or are currently listed for sale in the same or like areas. For instance, an industrial warehouse in Southern California would not be compared to an office building or to an industrial warehouse is northern California. In addition, since no two buildings are exactly alike, adjustments in comparable pricing are made based on factors such as location, land size, and building size, age and condition to reflect a more accurate apples-to-apples price comparison.
The cost approach starts with a simple premise – What would it cost to replace the building, starting from scratch and constructing it from the ground up? This three-step process starts with the land value, based on the market approach. Second, the direct and indirect costs to design and construct the building, such as labor, materials and administration, are added to the land value. Third, the depreciation costs of the subject property are subtracted from the land and building total to arrive at the Replacement Value.
The three types of depreciation costs in step three are physical, functional and economic. Physical refers to things that can be repaired or replaced, such as a broken hot water heater or chipped, cracked paint. Functional refers to non-desirable features like a low ceiling or no air conditioner. Economic refers to deterrents in location, such as being next to an airport or landfill.
The income approach is used for determining the value of income generating property, such as rental income property. In the simplest terms, the net operating income (NOI) is divided by the market capitalization (cap) rate, which is based on the property’s type, size, location and tenants to determine the property’s value. The higher the cap rate, the lower the property’s value. The lower the cap rate, the higher the property’s value.
Property valuation is not an exact science, however, utilizing the market, cost and income approaches, a property owner, investor or potential owner can arrive at preliminary values once evaluating all three approaches. For an in-depth property valuation analysis, contact your trusted and experienced commercial real estate agent.