Commercial real estate investors calculate the value of a particular property to determine the appropriate purchase price of real estate for sale, evaluate potential, and determine if it fits into their real estate portfolio. In this article, you will find a few of the common methods used in commercial property valuation.
Why Calculate the Value of Commercial Real Estate?
The value of commercial real estate matters in the investment’s purchase price and sale. When purchasing a property, investors need to be careful not to pay too much, otherwise, they won’t be able to turn a profit. That’s why they have to calculate the fair value – it enables them to determine the lowest feasible price to buy the property. Furthermore, it lets them see whether or not the property has the potential to earn as a rental.
The value of commercial real estate also helps investors calculate the profit they can receive once they sell their property. Naturally, they would want the value of their investments to rise over time, as this will allow them to put their properties up for sale at a more competitive price.
How to Determine the Value of Commercial Real Estate
Let’s review how you can determine the value of your commercial real estate investment.
#1 Income Approach
This is the most commonly used method in commercial real estate valuation. This valuation method contemplates the amount of income an investor can earn from a particular property. To determine the potential income, you can conduct a comparison of other similar properties in the area. For instance, if you own a shopping center, find out what other shopping centers earn – it would be safe to assume that you’d earn the same amount.
In this method, the value of a property can be determined by dividing the net operating income (NOI) by a predetermined cap rate. The cap rate is the rate of return of a particular piece of real estate and is applied to the NOI to calculate the present value. In general, a “good” cap rate is four to ten percent. A property management company can help you determine the appropriate cap rate.
For instance, if a shopping center generates $500,000 a year with an average cap rate of 7 percent, this method would value the property at $7.1 million ($500,000/0.07).
#2 Replacement Cost Approach
Another commercial real estate valuation method considers the replacement cost. This method is commonly used when comparable properties are hard to find. Also called the “Cost Approach”, this method is more complicated because it contemplates the value of the land in which the commercial property was built. It also factors in the cost to construct the commercial property from scratch and any additional costs that you’d incur to replace the structure.
It’s worth mentioning that, when calculating the value, the cost of materials needs to be up-to-date. Simply put, you can’t assume that the cost to construct your commercial property years ago is still the same to this date. If you aren’t sure how much the current construction costs are, you can consult a commercial property management firm.
#3 Market Value Approach
Also called the “Sales Comparison Approach”, this is the simplest method you can use to calculate your commercial investment’s value. This method is based on comparable sales data. And although it’s a rough estimate, it gives you a good idea of how much money you can generate.
To determine the value, a real estate professional such as a commercial property management firm will compare your property to properties of similar use. For instance, your office building may be set side by side against another office building that was sold a couple of months ago. Since no two properties are the same, your property management firm may also consider a number of discrepancies, such as the building’s age, condition, location, and more.
#4 Gross Rent Multiplier
The gross rent multiplier (GRM) method is another simple way to narrow down what properties you should buy. To determine the GRM, all you’ve got to do is divide the purchase price by the gross rent. With that said, the GRM of a property that generates $500,000 in rent per year and is priced at $5 million is 10 ($5 million / $500,000). As a general rule, the lower the GRM, the greater potential a property has.
#5 Cost Per Rentable Square Foot
This strategy subtracts the rentable area from the total area. It then compares the cost per rentable square foot to the average lease that you can charge per square foot. For instance, if a $10 million office building has 50,000 square feet, but only 45,000 square feet can actually be rented out (the rest are common areas), the cost per rentable square foot would be about $222 ($10 million / 45,000 SF). But if comparable data reveals that the average least cost per square foot is $250, you will be able to generate more rental income.
Why Invest in Commercial Properties?
Now that you know what methods to use in commercial real estate valuation, you may be wondering why commercial properties are one of the best investments you can make.
- Income Potential. Commercial properties earn more than residential properties. In general, they can generate an annual return of 6 to 12 percent of the purchase price (although this does depend on factors such as location).
- Tenants Are Aligned With Investor Goals. Commercial tenants are more likely to commit to property upkeep. This is because the property’s appearance can make or break their business.
- Not a 24/7 Job. Your tenants will close their doors at the end of the day. This means you can clock out when they do. You won’t have to worry about tenants calling you in the middle of the night because they locked themselves out.
Investing in Commercial Real Estate?
At Luxury Property Care, we want you to be sure about your investments. Through our investment advisory services, you can make sure you put your money into money-making properties. Whether you want to invest in a shopping center, office, or multi-unit commercial property, we’re here to give you the guidance you need. Aren’t sure about your calculations? Don’t worry – our team will crunch all of the numbers for you.