It is important to ask “What does it cost?” when buying commercial real estate, but it is even more meaningful when trying to price your own building and coming to a valuation that a buyer would want to pay. A commercial real estate valuation involves a mixture of science and art, we will focus on just a few valuation approaches you can use.

Source: Real Wealth Network

Knowing the right amount to pay can be the difference between a successful transaction and a losing one, whether you want to run a business out of the property, generate rental income from it, or fix it and flip it.

To sell your commercial building, processes and details need to be settled prior to stepping into escrow. For instance, you need to be fairly certain about its value, otherwise your property could sell under market or sit on the market for way too long. In an active, open, and competitive market, value is measured by the price that can be reasonably earned when both buyers and sellers approach the sale fairly and with knowledge. 

How to Value a Commercial Building:

The process of valuing commercial buildings can be complicated. A few approaches are available to try. Assessment of commercial building value is important since its sale and purchase depends on it. Here are the different approaches and the terminology you will need to estimate and complete your commercial property valuation.

Glossary of Valuation Terms for Commercial Real Estate

In this glossary, we provide a list of terms commonly used as part of the value-determination process.

Cap Rate

The capitalization rate is equal to the net annual rental income divided by the current value of a property. The analysis ignores the potential upside associated with below-market rents and financing. Whether a property should be sold for a profit or not is dictated by its cap rate.

Cost Per Unit

An investment property’s cost per unit can be calculated by dividing its purchase price by the number of rented units. Income, physical condition, or type or size of the unit are not considered in the calculation.

Debt Service

Debt service is the monthly payment of interest and the repaid principal for a commercial real estate loan or other debt.

Gross Potential Rent

Gross potential rent, also known as gross scheduled income, is the amount a multi-tenant property can collect after all rents have been paid in full and all units are rented out.

Gross Rent

Taking any incentives into account, this represents the actual rent the lessee pays. It is calculated by taking the average of the rent payments made over the months in which the lessee is required to pay rent.

Gross Rent Multiplier (GRM)

An estimate of the gross rent multiplier is calculated by dividing the sales price by the property’s annual gross potential rent. This rate does not take into account expenses, unlike the cap rate. It does not include physical defects or rents below market.

Net Operating Income (NOI)

A property’s net operating income equals the rental income less all the expenses associated with owning it, other than taxes and financing costs.

Here, present value is the sum of future rent payments, with each payment discounted according to time.

Price Per Square Foot

A property’s price is split by its square footage, without regard to whether it has one or more units, income, or is in good physical shape.

Commercial Real Estate Agents

A real estate agent’s duty is to represent buyers and sellers, lessors and lessees, as well as lessors and lessees in property transactions, and obtain a license from the state where they intend to practice. If you want to sell a residential or commercial building, you need the same license. If you have been asking, “what license is required to sell a commercial building?” In order to obtain the license, you must:

• Take pre licensure classes approved by the state
• Take the exam and pass it

There are different licensing requirements and regulatory offices in each state. A high school diploma, a background check, and a minimum age are common requirements. Obtaining a license in one state could give you access to practices in another state, too, if it has a reciprocal licensing agreement with other states.

Return on Investment (ROI)

ROI is calculated when cash flows after debt service are divided by investment costs.

TUMMI

The TUMMI acronym stands for tax, utility, management, maintenance, and insurance expenses related to real estate.

Vacancy and Collection Loss

Vacancy and collection loss refers to the loss of rental income due to unrented units and uncollected rent.

Commercial Property Valuation Approaches

Here are the methods used most frequently to determine a commercial property’s fair market value.

Cost Approach

Cost approach to valuing commercial buildings is equal to the land price plus the costs of constructing the building – or the costs of constructing a building similar – from the land price. Using a cost-approach, the value of a tract of land worth $40,000 is $640,000 if the cost of building a six-unit apartment house costs $600,000.

Using a cost-based approach, it is assumed that a property’s cost is determined by its highest and best use. 

When you have land in oil country or in a rural area, you should assume a value based on the property being used to generate oil income or some other higher and better use than being built into rental units for housing, which there may be no demand for. Zoning laws may also affect the use of a property and its cost approach.

When a phase of a new construction is completed, commercial real estate lenders release funds based on the cost approach. The main advantage of this method is that it provides a current value based on unique criteria. However, this approach fails to take into account either the future income or the comparable property price.

Source: The Balance Small Business

Income Approach

According to the income approach, value is linked to rental income via the cap rate of the property. Value of a property can be expressed as follows:

Current Value = Net Operating Income (NOI) / Cap Rate

Source: EDUCBA

If a rental property has an annual NOI of $700,000 and a cap rate of 8%, its current value would be $8.75 million ($700,000 / 8% = $8.75 million).

In the same neighborhood, the cap rate is calculated by extrapolating market sales figures. If the property has unique features, such as high-quality tenants or an aesthetically unattractive façade, the cap rate can be adjusted accordingly. Cap rates for comparable buildings should be within half a percentage point of the local average.

Source: Property Metrics

Advantages:

• The analysis can be adjusted to account for unique factors and recent closings of comparable buildings.
• Commercial real estate is typically valued through income analysis, which applies to any property that generates a consistent, predictable income stream.

Disadvantages:

• Does not take into account vacancy and collection loss, resulting in an overstated NOI and value.
• Additionally, it doesn’t take into account the cost of future extensive repairs.

Sales Comparison Approach

Based on recently sold comparable buildings and the asking prices of currently listed buildings, the sales comparison method for estimating commercial building market value, also known as the market methodology, relies on the prices realized from recently sold comparable buildings. Residential buildings, such as single-family homes and multi-unit buildings, are commonly appraised using the sales comparison approach.

To find recent sales or current listings of similar buildings, we will categorize the property’s features, such as the number of bathrooms and bedrooms, the square footage, and the lot size, and then find recent local sales. In a market filled with energy, particularly when sales have just taken place, it is a good idea to present recent sales.

Advantage:

• Provides a good estimate of value based on recent, relevant data.

Disadvantages:

• The relevancy of comparable buildings is affected by the unique features of many buildings.
• In some cases, it is not possible to determine the fair market value of commercial property by comparing sales that are too old. In other cases, current listing prices don’t reflect current values accurately.
• This calculation does not account for vacancy and collection loss, as well as unusual repairs and other expenses.

Commercial real estate agents are trained to account for differences between comparable buildings so the property can be valued accurately.

Advantage:

• Provides a good estimate of value based on recent, relevant data.

Disadvantages:

• The relevancy of comparable buildings is affected by the unique features of many buildings.
• In some cases, it is not possible to determine the fair market value of commercial property by comparing sales that are too old. In other cases, current listing prices don’t reflect current values accurately.
• This calculation does not account for vacancy and collection loss, as well as unusual repairs and other expenses.

Commercial real estate agents are trained to account for differences between comparable buildings so the property can be valued accurately.

Other Approaches

Capital Asset Pricing Models (CAPMs) have been proposed as a means of valuing real estate. As part of its CAPM methodology, a variable called “beta” is assigned that indicates how risk-adjusted returns from one asset and those from another are related.

Real estate values can be estimated by using a beta that correlates the return on income-producing rentals to, say, the return on publicly traded REITs. In real estate investing, CAPM can be overly simplistic because it does not account for all the risks involved, but it is simple for investors to use and understand. Because of this, CAPM is deemed of secondary importance until further research is completed.

An easy way to estimate the value of an apartment building is based on the value per door. If a comparable building with 10 apartments costs $2 million, then each apartment door would be worth $200,000. An apartment complex with 14 units with a value of $2.8 million could be valued by multiplying 14 by $200,000. Ideally, the apartments would be approximately equivalent in size. CAPM requires investors to adjust for a variety of factors, such as vacancy and collection costs, or unusual maintenance/repair costs. This can make it overly simplistic, but it is simple to use and understand.

Using recent sales prices and comparable buildings in your area can guide your decision on valuation. The process of selling a building can be simplified if you work with a broker who has experience with the type of building you’re selling and in your market. A broker who tells you that your property is worth $5 million might suggest that it would be worth $5.1 million or $5.3 million, and that would be a good price to list it at. It is not a good idea to make the property available for $5.5 million or more. 

Putting a price too high could lead to brokers who are searching for homes to sell ignoring the property thinking that the seller doesn’t mean business. Those looking for buildings to buy will say, “That deal is absurd, either the seller isn’t serious, or his broker has no clue what they’re doing.” 

While the property is on the market, you want the price to be competitive. Be realistic and don’t be greedy when valuing a property. Research comparable buildings next to yours to see what they are selling for. In addition, you should include any major repairs or issues a buyer will encounter after purchasing the property. This cost will be taken into account, and you should as well. 

Research the Market

Commercial real estate success relies heavily on doing your research and knowing your market, and setting an asking price is no exception. 

Identify what similar buildings are selling for in your market and find out what their price is currently. Prices need to be set based on current market data, so due diligence is essential to achieve the best results. It wouldn’t be wise to wait forever to drop your price. Instead, aim to set a price that makes sense from the beginning.

Choosing an appropriate price for a building can be difficult, but remember, you don’t have to do it by yourself. It is important to work with an experienced commercial real estate agent to manage your expectations and make sure that you ask for the right price. That is, not too high so that you maximize your profits, yet not too low that you don’t miss your deadline.

Are You Ready To Sell Your Commercial Real Estate?

For your commercial real estate sale to go smoothly, you will need the assistance of a real estate consultancy firm.

We here at Commercial Consult are committed to helping you sell your commercial property. Our team has completed more than a thousand commercial transactions, so rest assured that we will do our best to ensure your successful real estate transaction. Contact us today!