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Beauty is in the eye of the beholder. That famous line about subjectivity applies not just at the art auction and on the dating scene but also to buyers of commercial real estate. It’s tempting to think that the fair market value of a piece of property is a straightforward calculation that yields one correct answer and many wrong ones.
But it’s probably more useful to think of a reasonable price for any given piece of property as falling within a range. In cases when multiple bidders vie for a single property, chances are no two offers will come in at exactly the same amount.
Every investor, and every real estate appraiser, employs a slightly different approach to arrive at the “right” answer. And every investor is unique in terms of a variety of factors that influence that offer -- risk tolerance, cost of capital, past experience, inherent biases, confidence in the future, eagerness to win the property.
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Commercial real estate valuation is the art and science of determining how much a commercial property is worth. Variables include the location of the site, the age and condition of any structures on the site, and the property’s use.
Valuing a property is an exercise most commonly undertaken when the asset is on the market for sale. But valuation matters in other contexts, too. Perhaps the owner wants to refinance and a lender wants to ascertain the value of the underlying capital.
Maybe the parties need a valuation to negotiate the terms of a divorce or the dissolution of a business partnership. Whatever the reason, there will be times when the dollar value of a piece of real estate is a matter of intense scrutiny. Just how complicated the valuation is depends on the size and complexity of the property.
A newly built, 3,000-square-foot building leased to a single tenant on a long-term lease should be quick and easy to value.
On the other hand, a million-square-foot office tower, or a million-square-foot shopping mall, likely has many tenants with many lease terms and many potential economic uncertainties. More moving parts means more work for the analyst determining the value of the property.
The income approach is the most commonly used appraisal method. After all, a buyer of a commercial real estate asset is mainly concerned with how much income a property can generate – and, in turn, how much a future buyer might be willing to pay.
The income approach is based on two fundamental metrics -- net operating income, or NOI, and capitalization, or cap, rate. NOI is the bottom line figure generated by a property.
To calculate NOI, an investor sums up rents and other income, then subtracts operating expenses (but not capital expenditures, debt service, and taxes).
The cap rate, meanwhile, calculates the ratio of net operating income to a property’s value. So, if a $1 million property throws off $100,000 of NOI, the cap rate is 10. If a $2 million property generates $100,000 of NOI, the cap rate is 5. In other words, the lower the cap rate, the more richly valued the property is.
The income approach requires good data: A buyer or appraiser needs to know a property’s NOI, and then can assign a cap rate to calculate a value. Cap rates, like values themselves, are an ever-shifting thing.
In a gateway market like San Francisco or New York, cap rates tend to be lower. In secondary and tertiary markets, cap rates are higher, or less rich. The same applies to property types – a hot sector commands lower cap rates, while an out-of-favor property class is assigned higher cap rates.
What’s more, different investors have different opinions about reasonable cap rates. An aggressive and optimistic buyer might be willing to bid up the price and push down the cap rate. A cautious and conservative bidder will be less eager to pay more.
Sellers of institutional-grade properties often provide detailed net operating income information to potential buyers. Ideally, this puts everyone on a level playing field in terms of the information available. From there, it’s simply a matter of choosing a cap rate and doing the arithmetic.
However, if there’s a mistake in the NOI numbers or a future surprise that lowers the NOI, the income approach becomes less accurate.
Despite those potential pitfalls, the income approach is the gold standard of commercial real estate valuation. It’s the method taught in university classes on real estate finance, and it’s the approach most frequently cited by institutional investors, brokers, and appraisers.
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Another method for valuing a property is the cost approach. An analyst looks at the existing property and calculates how much it might cost to replicate the asset if it didn’t exist.
This approach seeks to take into account all the various expenses that an investor would incur in building the same property from scratch – the cost of the land under the building; the tab for concrete, steel, lumber, glass, stucco, and other building materials; the costs to pay contractors and subcontractors to complete the building.
The cost approach equates the value of commercial property with the cost an investor would incur to recreate the same property. The logic is appealing: The cost approach asserts that a savvy buyer wouldn’t spend more for a commercial property than it would cost to buy a piece of raw land and to put up a similar structure.
Costs to build new can be calculated in a number of ways:
The comparative unit method seeks to tally up a lump-sum estimate for the costs to build new on a per square foot basis. This approach goes so far as to dissect various categories of construction materials -- steel frame vs. concrete frame, block or tilt-wall, interior or exterior load-bearing walls.
The segregated cost method breaks out the individual cost of various building components, such as the cost to build a new roof, the prices of elevators and escalators, the price of a new HVAC system.
The unit-in-place method expands on the segregated cost method by getting even more granular. Instead of pricing the roof as one overall structure, this approach calculates the cost of individual roof joists and roofing tiles.
The quantity survey method might be the most accurate version of the cost method. It’s also the most time-consuming. In this painstaking approach, an analyst gets a detailed price estimate for every square inch of building materials in the building, along with bids for labor to replicate the structure.
The various cost approaches have a certain practical appeal, but these methods aren’t always realistic. Scarcity of land is one challenge – if the property in question is in a prime location in a central business district, or on a waterfront, there simply might not be another similar property available.
What’s more, building from scratch is an inherently risky process, one that requires navigating governmental approvals and construction delays. What’s more, in an era of resurgent inflation and clogged supply chains, there are no guarantees that building materials or construction workers will be available when you need them.
For those reasons, the cost approach is mostly used as a reality check – a back-of-the-envelope way to think about valuation, but not one broadly favored by commercial real estate investors.
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Another quick-and-dirty approach to commercial real estate valuation is the gross rent multiplier. Take the price of the property, divide it by the gross income, and – voila – you have an estimated valuation. This approach can help you spot commercial real estate assets that have a low price compared to their market-based potential.
Say, for instance, an investor assigns a gross rent multiplier of 8 to a property that generates $120,000 a year in gross rental income. The building would be worth $960,000.
The gross rent multiplier is a slightly cruder version of the income approach. This method doesn’t calculate net operating income, which in most cases offers a more realistic picture of a property’s income-generating potential.
This method, also known as the market approach, focuses on recent sales of comparable properties. By analyzing prices of recently sold buildings with similar uses within a geographic area, a buyer gets a sense of fair market value.
For example, a buyer looking at a 10-unit apartment building, or a 5,000-square-foot retail building, will research sales of similar assets.
The market approach is often used to value residential real estate, but the sales comparison method isn’t always applicable to commercial properties. That’s because commercial properties tend to have fewer comparable properties or comps.
A 2,000-square-foot house in a large subdivision is easy to value this way. But a large commercial property might be the only one of its kind to sell in a given market in a given year.
What’s more, homeowners don’t expect their houses to generate income, but commercial property owners do – so the rents paid by tenants in that 10-unit apartment building are probably more meaningful than how much another 10-unit building sold for.
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The cost per square foot might be considered a twist on the sales comparison approach. This is a straightforward exercise of dividing the price of a property by the amount of rentable square feet.
Say a 50,000 square foot office building just sold for $30 million. That equates to $600 a square foot. This metric lets investors and appraisers compare buildings of different sizes. What if you’re considering the purchase of a 30,000-square-foot office building nearby? Given the $600 square foot benchmark, $18 million would be a reasonable price.
Cost per square foot is a metric commonly used for property types that derive their income from leases based on rent per square foot – mainly offices, retail properties, and industrial buildings. Like the other back-of-the-envelope valuation methods detailed here, cost per square foot is an interesting data point – but one that has its limits.
Cost per square foot allows analysts to compare buildings of different sizes, but the total size of a building is just one variable. Vacancy rates, rental rates, and building age are other important factors that affect the earning potential of a property.
Cost per door adapts cost per square foot to property types – primarily apartments and hotels – that don’t quote their prices on a per square foot basis. In this valuation method, an analyst divides the price of a property by the number of hotel rooms or apartment units. Say a 50-room hotel just sold for $5 million.
That equates to $100,000 per room. Like cost per square foot, this method allows for the comparison of properties of different sizes. Exploring the purchase of a 70-room hotel across the street? Given the $100,000 per room standard, $7 million would be in the ballpark.
Cost per door is a nice number to know, but it shouldn’t be the end of your analysis. This method lets you compare properties of different sizes, but other factors might matter more.
For hotels, room rates, amenities, branding relationships, and other factors determine value. For apartments, vacancy rates, rental rates, and building age are other important factors that affect the earning potential of a property.
In case you haven’t heard, the commercial real estate market is on fire. As of early 2022, demand was high, prices were rising and cap rates kept getting lower and lower – and the Federal Reserve had yet to begin its round of long-anticipated rate hikes. The Green Street
Commercial Property Price Index for January 2022 showed that all property types were up 24% in the previous year. And values had recovered from the drop they experienced in the coronavirus recession – values were up 14% compared to the start of the pandemic in early 2020.
Some property types are especially hot. Industrial values soared at an eye-popping rate. The growth of e-commerce drove the pricing trend, Green Street said. As a result, cap rates have fallen in every major market relative to pre-COVID levels, but yields have declined by a greater magnitude in non-coastal markets.
In the apartment sector, fast-rising rents have placed downward pressure on cap rates in many regions of the U.S., including the popular Sun Belt metros and less-dense coastal markets, according to Green Street. Cap rates in those areas range from mid-3% to low-4%. And self-storage values also surged amid a housing boom and the work-from-home trend.
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There are multiple ways to value commercial property. Most investors and appraisers use more than one approach. They mix and match all of the methods above as they estimate the value of a property.
To become savvy spotters of value, real estate investors and appraisers should understand the inputs into these various equations. Ultimately, every buyer values property differently. The valuation of commercial property isn’t all dry spreadsheets and cold logic – emotions, opinions, and gut feel play a bigger role than most care to admit.
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