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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2006

3 Approaches to Valuing Commercial Real Estate

Knowing which route to take your client can seal a deal

As you know, commercial real estate is property used for business purposes. Implicit in this definition is that the property is income-producing or has the potential to produce income. The future net income and the eventual return of the investment capital are the main benefits to commercial property-owners.

Logically, a property that generates $1 million per year is worth more than a property that generates $1,000 per year. Hence, a property’s worth to a prospective buyer is based largely on its earning capacity.

Generally, the three approaches to valuing commercial property are the cost approach, the market approach and the income approach. It’s helpful for brokers to understand all three approaches so that they can effectively assist clients with varying needs.

Cost approach

The cost approach considers the cost of the land plus the replacement cost of improvements minus the physical and functional depreciation. The land value can be determined by studying recent land sales for sites close to the subject property; these sites should be comparable in size and zoning. Contractors must make adjustments for disparities.

If land comps are not available, land value can be determined through extraction — a method of approximating land value by estimating the depreciated cost of the improvements, then deducting it from the total sale price. Determining the depreciated cost of improvements requires a detailed knowledge of the type and class of construction and amenities.

Few people, including contractors, can give an accurate estimate of the cost to build or replace a property without extensive research. Commercial appraisers and taxing authorities typically rely on cost handbooks that are updated quarterly. These resources detail the costs of various building components and incorporate adjustments into the costs.

Market approach

This approach considers recent sales (not listings) of comparable properties. The properties need not be identical to the subject property in physical characteristics. But the use, land-to-building ratio, terms of sale and market conditions should be similar or easy to adjust for comparison.

To make the proper adjustments when comparing properties, appraisers must know the differences between the comparable properties. Further, they must know or be able to determine the value of those differences.

In addition to making adjustments based on financing and conditions of sale, adjustments may be necessary for all features recognized as valuable in the commercial real estate market.  

Income approach

The formula for this approach is simple: Value equals the net operating income (NOI) divided by the capitalization rate. Ultimately, this formula examines the relationship between NOI and value through applying the cap rate.

Although the income approach to value is the primary method of valuing commercial property, it has a flaw. If any one of the components in the formula is inaccurate, the answer will also be inaccurate.

These three components are critical to the property valuation. Look closely at each factor:

  • The net operating income is the biggest variable in the equation (see sidebar). Remember that because all the components of NOI vary from property to property, it can become subjective. 
  • The cap rate is determined by the buyer’s objectives. It is essentially the assumed annual return on an investment before mortgage payments and taxes.
  • The value varies, depending on whether the NOI is computing “as is” value or market value. If the valuation is as-is, then actual rents and actual operating expenses are used. If the valuation is market, then market rents, vacancy credit losses and operating expenses are used.

•  •  •

Of the three approaches, the primary method of valuing property depends on the buyer’s objectives or use of the property. For example, an owner-user would usually rely on the market approach. A buyer of a single-purpose property, such as a church, would use the cost approach. An investor buying an income stream would mostly rely on the income approach.

Know which is right for your situation.


 
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