How do you Calculate the Value of a Commercial Property?

Given how important real property assets are, understanding how the appraisal process works is a key first step in making various decisions about your real estate. How to calculate commercial property value will depend on the reason for the appraisal as well as the type of property being appraised and its value influences. Triggering events that would require knowing the value of your property include securing financing, estate planning, or tax issues. There are three main approaches used by appraisers to value real property investments, each with its own strengths and weaknesses.

How do you Determine Commercial Value?

Appraisers gather as much information about the property and market as possible before utilizing one or all three approaches to arrive at a market value. Given that each method provides its own unique value perspective, it’s common for appraisers to use a combination of all three to support a final value conclusion. The remainder of this blog segment will focus on providing the specifics of each method including when they’re most applicable, how they’re used, and how they compare to each other.

3 ways to Value Commercial Real Estate

In this post we’ll go over three of the most commonly used and effective appraisal techniques used in the industry which are the:

Direct Comparison Approach
Cost Approach
Income Approach

Direct Comparison Approach

The Direct Comparison Approach is based on the premise of substitution, or, that a rational investor will not spend more on a property than it would cost to acquire a similar one with the same utility and without undue delay. Therefore, the value of a property is indicated by the sales of similar, or comparable, properties in the market.

How do you know if a Sale is Comparable?

An appraiser will generally crossmatch key categories between properties to assess whether the sale is comparable or not. These categories include but are not limited to:

Location
Physical characteristics
Land use/zoning
Economic characteristics

It’s also important that certain information be known about each comparable property including the real property rights, financing terms, buyer/seller motivations, and market conditions.

How to do a Direct Comparison Approach?

The general process for conducting a Direct Comparison Approach (DCA) is

Researching similar properties which have recently sold
Verifying the data is accurate
Establishing the units of comparison (price per square foot or room)
Analyzing and adjusting the sale price of similar properties based on market data to account for variances between the subject property and the comparables
Reconciling the value indications into a value range or a single-point value

Adjustments for variances can be quantified by using paired sales analysis, statistical analysis, trend analysis, or cost analysis and can be percentages or dollar amounts. When quantitative data is lacking, a qualitative analysis is conducted; this rates the comparables as being similar, inferior, or superior to the subject; this type of analysis produces a value range that brackets the subject.

The DCA is commonly used as it best reflects the actions of buyers and sellers in the marketplace and is easily understood. However, the DCA also has some limitations; there must be sufficient comparable market data to produce reliable results; since sales are historic, they may not reflect current value in a quickly changing market; unique or special use properties are not suited to this approach.

Direct Comparison Approach Formula

The general formula for a direct comparison approach is as follows:

Where the variables denote:

Vx = comparable property

N = number of comparable properties used

A = variance adjustments

MV = market value

Cost Approach

The Cost Approach relates value to cost. It follows the same logic relating to the principles of substitution in that a rational investor will not spend more on a property than it would cost to get an equivalent one. Within this approach, the cost of new construction less any depreciation is added to the value of the land to reach a total market value.

When would you use the Cost Approach?

The Cost Approach is especially useful for valuing special-use or unique properties such as churches, libraries, or hospitals, or for those that do not generate income, as well as for new, or newer, construction, and for insurance underwriting.

This approach loses reliability in older properties or those that have undergone various renovations because depreciation can be difficult to estimate. Another limitation is the assumption that there is an availability of similar vacant land which may not always be the case, particularly within urban areas that are developed.

Cost Approach Formula

The formula for the cost approach is as follows:

Where the variables denote:

MV = market value

LV = land value

CN = cost new

DA = accumulated depreciation

Cost Approach Example

Let's suppose that a non-profit organization needs to know the market value of its property for Canada Revenue Agency reporting purposes. The property consists of a 5,000-square-foot, three-year-old building located on a half-acre in a rural area. Sales data indicates that the value of the land is $125,000. Construction cost data indicates that it would cost $150 per square foot to replace the building in the current market. Using the age-life method of deprecation, the age of the building is divided by the total life of the building, to arrive at the amount of deprivation. Assuming the building has a total economic life of 60 years and is three years old, the depreciation amount is 5% (3/60).

Therefore, the market value estimate of the property is calculated as follows:

Land value + ((Cost New) – (Depreciation)) = Market Value

$125,000 + (($150 x 5,000) – (($150 x 5,000)x 0.05)) = Market Value

$125,000 + ($750,000 - $37,500) = Market Value

$837,500 = Market Value

Income Capitalization Approach

Most commercial properties are purchased as investments, therefore, earning potential is directly tied to value. In the Income Approach earning potential is based on the Net Operating Income (NOI) and a market capitalization, or cap, rate. The NOI is the gross operating income less operating expenses. A cap rate is the rate of return sought by investors; this is usually based on the market sales of similar properties. Rents and expenses are also arrived at by analyzing properties of similar size, location, and utility.

Within the Income Approach, the appraiser can either apply direct capitalization or yield capitalization. Direct capitalization uses one years’ income and expenses to establish a value, while yield capitalization is based on a series of cash flows over a period of time, say 10 years, plus the proceeds of resale. Yield capitalization is typically used for larger multi-tenanted properties which are susceptible to cash flow fluctuations.

For most smaller investments, direct capitalization is used as it is simple to apply and easily understood.

What are the Steps in the Income Capitalization Approach?

Estimate the potential gross income (PGI)
Estimate vacancy and collection allowances
Subtract the vacancy and collection allowance from PGI to get the Effective Gross Income (EGI)
Estimate the total operating expenses
Subtract operating expenses from the EGI to arrive at the NOI
Apply the market-derived cap rate to the NOI

Income Capitalization Approach Formula

The formula for the Income Capitalization Approach is as follows:

Market Value = Net Operating Income (NOI)

Capitalization Rate

Cost Approach vs Income Approach

Overall, the Income Approach is more accurate and reliable than the Cost Approach. The disadvantages of the Cost Approach include the assumption that there is enough vacant land available to build an identical property, depreciation can be hard to estimate, particularly in older properties, and that in quickly changing markets it lags behind current market pricing. The Income Approach is highly accurate because it determines value based on a property’s income potential. This is the most relevant indicator of an investment’s worth. This method is also highly flexible, allowing for the assessment of various classes of investment properties.

What Valuation Approach is most Commonly used for Commercial Real Estate?

Typically, the preferable method to value commercial properties is the Income Approach, however, a value estimate is generally supported by more than one method. Based on the type of property being appraised, one, two or even all three approaches will be applied to support the final value estimate. The decision regarding which approaches are applicable will be based on the characteristics of the property being appraised as well as the purpose and intended use of the appraisal.

References

Appraisal Institute of Canada. Understanding the Fundamentals of Appraisal. Ottawa, ON: Appraisal Institute of Canada, 2018.
Lawver, Matt. “The Pros & Cons of Each Valuation Approach.” Value Scout - Exit Planning 2.0, November 10, 2021. https://getvaluescout.com/blog/intermediate-valuation-pros-and-cons-of-each-valuation-approach/.
Liberto, Daniel. “Cost Approach Definition.” Investopedia. Investopedia, May 19, 2021. https://www.investopedia.com/terms/c/cost-approach.asp.
Propertylogymagazine. “Formula – Sales Comparison Approach Property Valuation.” Propertylogy. Accessed June 15, 2022. https://www.propertylogy.com/academic/sales-comparison-approach/.
Propertymetrics. “The Cost Approach to Real Estate Valuation.” PropertyMetrics, July 23, 2019. https://propertymetrics.com/blog/cost-approach/.
Propertymetrics. “The Income Approach to Real Estate Valuation.” PropertyMetrics, July 23, 2019. https://propertymetrics.com/blog/income-approach/.
Sauder School of Business. “Direct Comparison Approach.” Sauder School of Business Real Estate Course Resources. Accessed June 15, 2022. https://professional.sauder.ubc.ca/re_creditprogram/course_resources/index.cfm.
Tower59. “Valuation Methods – the Income Approach.” Simple409a.com. datadrivendesign https://simple409a.com/wp-content/uploads/2016/12/logo-site-smaller.png, December 21, 2016. https://simple409a.com/the-income-approach/.