How Is Commercial Real Estate Valued?

In the twenty-seven some odd years I have been in the commercial real estate business, I have been asked quite frequently how we, in our profession, value property.  Things like “How do you value a piece of commercial property?”, “What do you think my property is worth?”, “How do I go about purchasing commercial property?”, etc.

What I will attempt to do in the paragraphs below is to touch on the basics of real estate valuation.  Commercial brokers use these tools in helping their clients, and commercial appraisers use these same tools in more depth to perform qualified appraisals for commercial properties.

Generally speaking, when a broker is estimating value he first determines what type of property he is valuing.  Is it income producing?  Is it vacant property or is the owner trying to sell?  Or is it a user piece of property that a purchaser is trying to buy?

Commercial brokers and appraisers alike use the following approaches to value property.  As I stated before, commercial brokers generally do not get into great depths on the valuation process, except to try and get a ball park figure on a piece of property; whereas, appraisers use more in-depth and concise methods of reading an estimate of value.

Now, let’s get into the three approaches of estimating value.

 

  1. The Market Approach, sometimes known as direct sales campaign approach, is an estimate of value based on the actual sales price of comparable or similar properties that have sold in the open market.  In determining value with this approach, the broker or appraiser has to research the market for recent sales of buildings similar to the property they are valuing.  This is typically done by canvassing fellow brokers on their recent sales or by searching deeds, either at the county court house, or in some cases, online.

 

  1. The Cost Approach is an estimate of value based on current construction costs, or determining the replacement cost of a building, less depreciation, plus land value.  Most professionals generally do not use the cost approach; however, this method is helpful when valuing one of a kind or special use properties.  If the cost approach is used, there are several factors to be considered:
  • Estimate the land as if it is vacant.
  • Estimate the cost to replace the building.
  • Estimate the buildings loss from depreciation.
  • Take away the depreciation from the replacement cost.
  • Finally, add the estimated land value to the depreciated value.

 

  1. The Income Approach is an estimate of value based on an income producing property such as office buildings, warehouses, apartment buildings and shopping centers.  Also, when using the income approach, you will need reliable financial data available from recent sales of comparable income producing properties in the market.  When using the income approach, as with the cost approach, general factors will need to be considered:
  • Potential gross income – which is the annual gross income for a property fully leased.
  • Effective gross income – which is the potential gross income minus a vacancy allowance.  Vacancy allowance is usually determined by current rental market conditions for the type of property you are valuing.
  • Operating Expenses – these are expenses that are used to operate the property.  They are deducted from the effective gross income.
  • Net operating income (NOI) – the income that is devised once you subtract the operating expenses from the effective gross income.

Once the NOI is determined, the market cap rate is used to determine the value of the property.  This is where the financial data from recent sales of comparable income producing properties come into play.

The formula for calculating the market value is as follows:

Net Operating Income
Capitalization Rate                  =Estimated Market Value

This is just a brief synopsis on how commercial properties are valued.  With the information above, most qualified commercial brokers can help his client arrive at a value.  However, if someone is looking for the most accurate value for a property, I would recommend a certified commercial appraiser to perform the valuation.

 

Donnie Laurens
Commercial Real Estate Agent
Macon Commercial Office
478-746-9421