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When you are ready to buy or sell a commercial property, knowing its value is crucial to having a successful transaction for the buyer and seller. Value means the most feasible price the property could fetch in any market. Now, remember that valuing a commercial property presents a difficult challenge and it’s much different than valuing residential real estate. But don’t worry, below we will go through several ways professionals value commercial real estate in hopes that you can correctly value your property for a fast sale or purchase.
Finding out what your property is worth is essential for real estate investors and lenders when looking to purchase or sell. Real estate investors like to calculate the value of every property they are looking at to determine a fair purchase price, evaluate different opportunities in different markets, and decide whether or not a property is a good fit for their portfolio.
On the other hand, lenders use the value to determine the down payment needed and the mortgage length for commercial property purchases. This part is called the “underwriting process” and it is a part of all real estate investments.
Before we continue, there is a very important point we need to establish. The cost of a real estate property and the value of a real estate property are two very different things. The cost is the actual amount a real estate investor pays for a property where the value is the potential the investor sees in the property. This is important because every investor wants to make sure they are getting themselves into a profitable investment that will continue to be profitable for years to come.
When valuing a property investors focus on four different things:
Every potential investment property needs to have all four of these characteristics to be valuable. Even if your property has desire, scarcity, and you have the purchasing power but it has no utility, then that property is not nearly as valuable as first thought.
If you haven't noticed already, real estate jargon is quite relevant on the commercial side of things. Before you start negotiating purchase and sales prices, here are some terms to be familiar with.
Net Operating Income (NOI) - Subtracts the building's operating expenses besides debt from the property's annual income.
Cap Rate - This is calculated by dividing the annual NOI by the building value. Commercial real estate investors use cap rates to forecast the future return on a property.
Price Per Square Foot - Calculated by the price of the property divided by the square footage of the property. This calculation does not take into account any other factors like building location, age, and more.
Value - This is the estimated worth of the property or selling price based on one of the six valuation methods below.
Gross Rent - This is the total income of the property including rent, covered parking, pets, and more.
Debt - Is the principal and mortgage owed on the property that was used to purchase the property.
Valuing commercial property is not as straightforward as valuing residential real estate, and I'd say it is much more difficult. But don’t worry, with some practice you can become an underwriting pro. Below I have listed some of my favorite methods to use when valuing potential investments. I encourage you to test out a couple of different ones and compare the value you get in each estimation.
The gross rent multiplier calculation or GRM is a simple way to compare properties and find out if a property is valuable based on a few numbers. To calculate the GRM you will need to know the annual rental income and the purchase price of the property. Let’s say the property brings in $500,000 a year in rental income and the purchase price was $7,000,000. The GRM would be calculated by:
$7,000,000 / $500,000 = 14
The closer the GRM is to 1, the more potential a property has as a profitable commercial property.
You need to keep in mind that this type of calculation does not include variables like vacancy, expenses, and repairs.
You will need to find some recently completed sales in your area for similar properties, also known as “comps”. This approach is more common in the residential aspect of valuation but can still be valuable to do for commercial properties as well. If you are looking to sell or buy a 12-unit apartment building, then trying to find a recent sale of one in your area would be a great way to start your sales comparison valuation.
Another easy way to value a property is to find the average cost per door in your area. If a commercial property that recently sold for $3 million has 15 units. Then the cost per door would be:
$3,000,000 / 15 = $200,000
This calculation can get you a nice ballpark figure to work with but it does not factor in the size of the units, bedrooms per unit, and how new the units are.
The cost approach is used when pulling comps is difficult for a certain property or nonexistent. The cost approach finds the value of a property by considering the cost of the entire property from the ground up including the land value, materials, construction cost, and more.
This approach is used to determine the potential rental income of a property. You do this by subtracting the rentable square footage from the building's total square footage. If a building is $15 million and has 50,000 square feet and 10,000 is used for common areas, gyms, and laundry. Then you would take $15 million / 40,000. The cost per rentable square foot would be $375.
The income capitalization approach used the net operating income or NOI a property generates to determine the property's value compared to similar buildings in the same market. If apartment buildings in Miami are trading at a 7.8% cap rate and similar apartment buildings are generating an NOI of $1,000,000 per year. The income capitalization approach would value a building at $12,820,512 ($1,000,000 / 7.8%).
Every commercial real estate professional uses different methods when trying to value a property. There is no perfect way to do this and it takes a mixture of market numbers, math, and your gut feeling. If you follow this guide and use a mixture of the methods above to value your property. Then you should have an accurate number of what the property is worth and a better idea of what it is valued at when negotiating.
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