6 Commercial Real Estate Valuation Methods

Valuation is a crucial component of any commercial real estate investment. Determining the value of a property is important to sell a building or recoup money from an investment. There are many methods that valuers use to determine the value of a property. Each of these methods has its advantages and drawbacks.

The cost approach is one of the most common valuation methods for commercial real estate. It considers the costs of land and construction plus the depreciation of those improvements to calculate a property's market value. The cost approach can be useful in some situations, especially if there are no comparable properties to use as reference points. This method is also frequently used when special-use buildings or historic structures exist.

The logic behind the cost approach is that a rational buyer wouldn't pay more for a building than it would cost to build an equivalent property. So, to estimate a property's market value, appraisers need to know the amount of money needed to construct an equivalent building from scratch.

The Sales Comparison Approach is among the most common and widely used valuation methods. It is used by real estate agents and appraisers when determining the value of a property. The sales comparison approach involves analyzing recent sales of similar properties and determining their value based on market factors. It uses data from comparable homes sold in the same neighborhood or subdivision as the subject property.

This approach focuses on the similarities between properties sold in the same area and is often used by commercial real estate appraisers. It also identifies the features that can affect a property's value. These include square footage, number of bedrooms and bathrooms, location, and any value-add amenities.

Adjustments are made to the price of a comparable property to account for differences in these aspects. For example, if the comparable property has smart appliances in its kitchen and the subject property doesn't have any, the sales price of the comp needs to be adjusted accordingly.

The Direct Comparison Approach is a relatively simple method of valuing properties. It relies on comparing a subject property with similar sales and adjusts these prices based on how closely they match the subject property's characteristics.

When evaluating sales, appraisers must consider differences in the buildings themselves, their age and condition, and any property rights being transferred. These can include property rights such as a fee, simple interest, easements, and deed restrictions.

The other major consideration when comparing sales is economic characteristics such as operating expenses, management fees, and lease terms. These differences can significantly alter expected net operating income, ultimately affecting a property's value.

The income approach is one of the three commercial real estate valuation methods that appraisers use when valuing properties. It is most commonly used with property types that generate rental income, like offices, apartments, shopping complexes, and industrial properties.

The value of a property is based on its expected future income and expenses. Appraisers estimate the property's net operating income and a capitalization rate, the discounted net operating income divided by the price at which it could be sold.

To calculate a net operating income, an appraiser estimates the potential gross income of the property and subtracts the allowed vacancy and collection losses. These losses are based on market and local conditions. Next, an appraiser estimates operating expenses, including normal recurring expenses tied to the building, such as property taxes, utilities, and non-capital repairs. These are then subtracted from the potential gross income to get the income that can be capitalized using the appropriate capitalization multiplier or rate.