Valuating commercial properties is one of the most useful skills you can learn as a property investor. Whether you’re looking to buy a commercial property or valuate your existing property for tax purposes, obtaining an accurate valuation is crucial.
Why Commercial Property Valuation Matters
Property valuations matter for several reasons. The main reason is that it allows buyers to invest in real estate without overpaying. Since property valuations accurately determine the market value of a property, buyers can confidently acquire properties at a reasonable price.
Likewise, sellers can make use of property valuations to bump up the price of their properties, ultimately helping them maximize their returns. Property management companies also make use of property valuations to determine the amount of rent to be imposed at their clients’ rental properties.
Property valuations are also useful to lenders and banks. This is because they are more likely to lend to property owners with high-value properties, as these can be treated as collateral to pay off loans.
Terms Used in Real Estate Valuation
Before we jump into the methods that real estate investors used to predict the value of a given commercial property, let’s take a look at some of the key terms you should know:
#1 Cap Rate
The cap rate refers to the commercial property’s projected rate of return. It is calculated by dividing the net annual rental income by the current value of the property.
#2 Cost Per Unit
The cost per unit is calculated by dividing the price of the property by the total number of rental units. For instance, the cost per unit of a $500,000 commercial property with 50 rental units would be $10,000.
#3 Debt Service
The debt service refers to the monthly or yearly payments to cover the principal cost with interest.
#4 Gross Potential Rent
The gross potential rent refers to the collectible rent, assuming that every unit in the multi-tenant commercial property is occupied and that the rent is paid in full.
#5 Gross Rent
Gross rent or the “effective gross rent” is calculated by dividing the total amount of rent that a tenant has to pay in a commercial lease by the length of their contract in terms of months.
#6 Gross Rent Multiplier (GRM)
The gross rent multiplier (GRM) is determined by taking the sales price of the commercial property and dividing it by its annual gross potential rent. GRM does not take into account the expenses but merely paints a picture of the inflow of rental income.
#7 Net Operating Income (NOI)
The net operating income (NOI) can be attained by deducting operating expenses such as maintenance, utilities, etc. from the rental income of the commercial property.
#8 Price Per Square Foot
To get the price-per-square-foot or the “price-per-pound”, divide the purchase price of the property (or the total cost incurred to develop the property) by the total square footage.
#9 Return on Investment (ROI)
The return on investment (ROI) is calculated by dividing the cash flow after debt service by the cost of the investment.
The value is a commercial property’s estimated price in the market. It is obtained by applying one of the methods which will be discussed below.
Best Methods for Valuing Commercial Real Estate
Real estate investors, property managers, lenders, etc. utilize a variety of methods to determine the value of a commercial property. Here are some of the most common commercial property valuation techniques:
#1 Cost Approach
The cost approach, otherwise known as the “replacement cost”, considers the cost it would take to construct or reconstruct a given property. It combines the various costs — such as land, labor, materials, etc.– to determine the value of the property.
For instance, if a one-acre lot costs $200,000 and building a shopping center costs $1.5 million, using the cost approach, the value of the property is at $1.7 million.
#2 Income Capitalization Approach
The income capitalization approach focuses on the income that the property is expected to generate. Under this approach, you will first have to determine the commercial property’s net operating income (NOI). Once you’ve determined the NOI, divide it by the cap rate to determine the current value of the property.
#3 Sales Comparison Approach
The sales comparison approach, commonly known as the “market approach”, compares a given property to recently sold properties (called “comparables”) within the same market. For instance, you could compare a three-story office building with nearby office buildings with the same square footage.
However, this approach does not apply to properties with one-of-a-kind characteristics. This is why the sales comparison approach is rarely used to determine the value of commercial properties. It is better suited for residences.
#4 Value Per Door
This approach takes into account the number of units or “doors” that a commercial property has to determine its current value. For instance, if a shopping strip with 30 rental units costs $600,000, then the value per door would be $20,000.
However, the value per door method applies only when all of the units are of the same size, square footage, quality, etc. Additionally, it’s important to note that while this valuation approach is simple, it is not the most accurate.
#5 Value Per Gross Rent Multiplier
This valuation approach is similar to the income capitalization approach. The difference is that the value per Gross Rent Multiplier (GRM) method is based on gross rent, not net operating income (NOI).
To determine the value of the property using this method, simply multiply the annual gross rent by the GRM. If you don’t know how to calculate the GRM, you can ask a property manager or a real estate professional.
There’s no such thing as the “best” valuation approach. It’s important to keep in mind that as a property investor, you should follow the approach that best suits your commercial property’s situation. For instance, if there are plenty of nearby properties that are similar to yours, you may want to use the value-per-door approach.
Commercial properties are serious investments. They are usually priced higher than residential properties, which is why you need to come to an accurate valuation of a given property before finalizing a sale. By doing so, you can avoid buying unprofitable properties, and instead, benefit from properties that generate your desired ROI.
For nearly a decade, Luxury Property Care has been conducting property valuations of commercial properties within South Florida. Our expertise has helped hundreds of real estate investors determine the best possible prices for their properties, as well as identify which ones they should add to their investment portfolios.