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Understanding Commercial Property Value

Table of Contents

Commercial property value can be a complex calculation, depending on the property’s type, its use, the reasons for the valuation, and a variety of factors that one can take into consideration. You can use several methods for calculating the value of commercial property, including the commonly used approaches detailed below.

Why You Might Want to Know a Commercial Property’s Value

Your purpose in learning a commercial property’s value will differ depending on your position as a buyer, seller, investor, or owner. As a buyer, you want to understand the commercial property’s value to assess the reasonableness of the asking price for that property or a similar property. Similarly, a seller wants to establish a fair price to accept. Investors will evaluate a property’s present and anticipated property value when making an investment decision and when leveraging a portfolio’s value for business purposes. And an owner needs to know a property’s assessed value for tax purposes as well as for insurance coverage, for example.

Residential vs. Commercial Property Valuation

Residential property, which includes single family homes and condos as well as duplexes, triplexes, and quadplexes, is relatively straightforward in its valuation. The value of residential property generally derives from the market. To determine a residential property’s value, you use a comparable sales approach: look at the sales prices of similar homes in the same or similar market and adjust for differences. Commercial property, however, depends on the income it produces. Commercial real estate includes multifamily residences of five or more units, office buildings, warehouses, factories, retail stores, shopping complexes, and other property types used by a business.

Glossary of Common Property Valuation Terms

To understand the calculations that determine commercial property value, you should familiarize yourself with certain terms those formulas use.

Cap Rate: The capitalization rate, or cap rate, provides a snapshot of a property’s expected rate of return on investment and equals the property’s net operating income divided by its current value. Any mortgage or financing debt is not considered.

Gross Potential Rent: The gross potential rent, or GPR, is the amount of rent that could be collected from a property if all units were completely rented and all rents paid in full. This also is referred to as gross scheduled income.

Gross Rent: The gross rent, or effective gross rent, is the average rent taken over the months the lessee is obligated to pay rent.

Gross Rent Multiplier: Also known as the GRM, the gross rent multiplier divides the sales price of a commercial property by its annual gross potential rent. The gross rent multiplier ignores expenses and physical condition.

Net Operating Income: Net operating income, or NOI, equals the actual rental income from a property minus the expenses, such as maintenance costs and property taxes, associated with ownership.

Vacancy and Collection Loss: Unrented units do not provide income, and uncollected rents represent lost income; together, the unoccupied units and rent not collected from occupied units comprise the vacancy and collection loss.

Methods of Calculating Commercial Property Value

With residential real estate, you invest in the land and the buildings on that land. With commercial real estate, you invest not just in the buildings and land, but the tenants, leases, and income generated within those buildings. With different markets, property uses, and income-generating sources, you might use a different calculation. The most common calculation methods follow.

Sales Comps

To use the sales comparables, or comps, method, you need the selling price for similar properties. Searching ProspectNow‘s database that contains millions of commercial properties’ details can be useful in locating relevant properties. For this model, properties ideally should be comparable in condition, location, square footage, age, number of units, and commercial real estate sector. After calculating the average price of several similar properties that have recently sold or are listed for sale, adjustments must be made to allow for positive or negative differences between the properties.

The sales comp approach does not factor in the property’s expenses or its current financial performance in relation to its potential income. For example, the calculation does not account for vacancy and collection loss or unusual expenses.

When the comparable sales approach is useful:

This model is the primary method used for residential real estate valuation, and it is the simplest calculation. Sales comps are common with appraisers and brokers. The comparable sales approach is most useful when recent, relevant data is available that can provide a good estimate of current value.

Cost Approach

With the replacement cost method, commercial property value totals the value of the land and the value of the building. The value expresses the total cost to rebuild the property, including the materials needed to replace the building itself and the value of the underlying land. The cost approach accounts for the property’s current condition, construction costs, and comparable sales of similar properties. However, this method does not account for the income the property will produce in the future.

When the cost approach is useful:

Tax collectors commonly use the cost approach to determine the taxable value of property for annual tax assessments. This valuation method also is popular with property insurers and with lenders needing to release funds with the completion of new construction phases. The cost approach is useful when you cannot locate reasonable or recent comparables, such as when the property includes unique or specialized improvements, or when upgraded structures significantly increase the underlying land’s value. The cost approach’s primary advantage is its ability to calculate a current value based on unique conditions.

Income Approach

The income approach to commercial real estate valuation divides the NOI by the cap rate (see above for definitions of these terms). With this method, you need to know the property’s NOI, or its rental income and operating expenses, as well as the market cap rate. The cap rate varies according to the property’s location, age, type, and condition.

The main disadvantage to the income approach is its tendency to inflate the NOI, by not accounting for vacancy and collection loss and by not considering necessary extensive repairs that will decrease future NOI.

When the income approach is useful:

The income approach is one of the more popular commercial property valuation methods, since it helps to determine a property’s worth as it relates to its current cash flow in the current market. It not only accommodates for recent sale activity of comparable properties, but it can be adjusted for unique factors.

Gross Rent Multiplier

With this approach, a commercial property’s value comes by multiplying the annual gross rent by a gross rent multiplier, or GRM. A property’s GRM usually is the average of comparable properties’ GRMs, which is the gross rent divided by the sales price. The gross rent multiplier approach does not consider the property’s expenses or its vacancy and collection loss. Also, if you cannot accurately calculate a GRM, then this approach cannot be used. Look for comparable properties’ sales prices in available property databases, such as ProspectNow.

When the gross rent multiplier approach is useful:

If an accurate estimate of GRM can be made, then this approach works well for identifying property with a low price relative to its projected potential income. This approach’s advantage is its simplicity, though it is most useful when used in combination with other valuation methods.

Use of a property information tool such as ProspectNow provides invaluable information useful for calculating the value of commercial real estate. Whether you are looking for commercial property to buy or have a property to sell, take advantage of the extensive market data found on the ProspectNow platform.

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