At a time when the Federal Reserve has increased benchmark interest rates at a record pace (11 times since March 2022), it’s no wonder mortgage professionals are having a difficult time valuing commercial properties. Additionally, fears of crashing values have spooked the market. Capital Economics estimated this past summer that commercial real estate values could crater by as much as 40% in some major cities.
As a mortgage broker engaged to procure financing, one must have the ability to determine market values, especially in a fast-changing environment. Borrowers and lenders alike rely on brokers to guide the conversation around property values, thus determining the ability to finance these assets.
While some lenders will require an appraisal, a broker’s opinion of value will hold more weight when working with a private money lender. There are two primary methods for valuing commercial real estate — the income approach and the sales approach — that brokers should thoroughly understand.
Income approach
The income approach dives deep into the financial health of a property. It is a fundamental method for appraising a variety of income-producing properties, from office buildings and warehouses to apartment communities and shopping centers.
This approach estimates value based on the current income or the future income to be generated by the property. The primary components of the income approach are the net operating income (NOI) and the capitalization rate.
“As a mortgage broker engaged to procure financing, one must have the ability to determine market values, especially in a fast-changing environment.”
NOI is calculated by subtracting all operating expenses (excluding mortgage payments) from the property’s gross income. Operating expenses include property management, maintenance, insurance, utilities and property taxes. While each asset has its own specific expense structure, it is common for expenses to range from 25% to 50% of the gross income.
Take, for example, an apartment building that collects $150,000 a year in gross rental income and has expenses of $50,000 (a 33% expense ratio). In this instance, the NOI totals $100,000.
The capitalization rate, meanwhile, represents the investor’s expected rate of return on a property and is one of the most widely used formulas to determine value. To calculate the cap rate, divide the NOI by the property’s current value. If the aforementioned apartment community with a yearly net income of $100,000 is valued at $2 million, the cap rate is 5%.
Conversely, an investor seeking to purchase a property can determine its value based on their desired rate of return. If an investor requires an annual return of 8% on the same apartment building, for example, they would divide the NOI of $100,000 by the cap rate of 8%. This would lower the estimated value of the property to $1,250,000.
Cap rate expectations
Although cap rates are subjective and are based on an investor’s required profit margin, there are generally accepted cap rates throughout the marketplace. Over the past few years, investors have typically used cap rates of 4% to 9% to determine values.
Typically, lower cap rates are used for higher-quality properties in primary markets that are considered safer and thus yield a lower return. Conversely, higher cap rates are used for lower-quality properties in secondary and tertiary markets where investors need a higher yield to compensate for the additional risk.
Since cap rates adjust based on location, demand and interest rates, it’s important to stay up to date on currently acceptable ratios. As a rule of thumb, cap rates are typically 1% to 2% higher than current interest rates, which saw historically fast upward movements from 2022 to 2023.
Be sure to reach out to local sales brokers to get a good sense of market cap rates. You should also take advantage of the research reports published by major real estate companies (including CBRE, JLL and Cushman & Wakefield) that offer a variety of market insights.
The income approach is particularly valuable for income-producing properties as it directly considers the property’s potential to generate revenue. But it’s essential to have accurate income and expense data when calculating the NOI and selecting an appropriate cap rate.
Sales approach
The sales approach (also known as the comparison approach or market approach) is another common method to determine the value of a commercial property. This approach relies on analysis of recent sales of similar properties in the same market to estimate the subject property’s value.
To begin, gather data on recently sold properties that are as similar as possible to the subject property in terms of size, location, age and use. These properties are referred to as “comps” or “comparables.” This information can be provided by real estate brokers, collected from public records, or downloaded from data aggregation services such as CoStar or Crexi.
Once this information is collected, the focus turns to the price per square foot (PSF). For example, if a similar property of 10,000 square feet recently sold for $1.5 million, the PSF is $150. Determine the PSF for each of the comparable properties and calculate an average. Once you have an average PSF, a value for the subject property can easily be determined.
While the sales approach is relatively simple and straightforward, there are a few items to consider to ensure that values are accurate. First, make sure the comparable properties are truly comparable. For example, one should not compare a property built in 2020 with one from the 1960s as the values will be drastically different.
You could have two identical buildings that are in different locations, which could equate to vastly different values. Always remember the old adage of “location, location, location,” as investors are willing to pay higher prices for real estate in better locations.
The sales approach is particularly useful when there is an active market with a sufficient number of comparable sales. Naturally, it may be less reliable for specialty properties, or ones that lack recent comparable sales data.
● ● ●
Until the commercial real estate market stabilizes, it will continue to be difficult to obtain financing for transitional and cash-flowing properties. Mortgage brokers who master these valuation approaches will thrive by helping clients make informed decisions, maximize returns and secure favorable debt for their real estate portfolios. ●
