Real estate appraisal is both an art and a science. Brokers, agents, owners, and investors use appraisals to determine a property’s market value. At the most basic level, the market value is a property’s selling price on the open market. But how do you determine the value of a piece of real estate? Below, we’ll look at a few basic concepts which relate to commercial property values. Then we’ll review three common real estate appraisal methods: sales comparison approach, income approach, and cost approach.
Basic Terms and Concepts
When speaking to various commercial real estate professionals, you might hear terms like value, cost, price, or market value. But what do these terms actually mean? Before diving into valuation methods, let’s explore these basic concepts in relationship to commercial real estate.
- Value: The worth of a property’s benefits to the owner over a period of time.
- Cost: Actual expenditures like materials or labor.
- Price: The amount that you pay in exchange for a good.
- Market Value: An estimate of a given property’s sale price based on an appraisal made on a specific date.
As you can see, value and market value aren’t the same thing. Value influences market value, but many other factors must be considered as well. According to Investopedia, there are four factors that influence property values: demand, utility (or usability), scarcity, and transferability. Also, value estimations must take into account governmental regulations, economic and social trends, and environmental conditions.
Likewise, the cost and the price of a given commercial property aren’t the same either. And although cost and price might influence a property’s value, these don’t determine its value. For example, if you pay $500,000 for a property, the actual value could be higher or lower.
Valuation Methods for a Commercial Real Estate Appraisal
Below are several commonly-used valuation methods for a commercial real estate appraisal.
Sales Comparison Approach (Comparison Method)
Also known as the ‘comparison method,’ ‘market approach,’ or the ‘market data approach,’ this valuation method considers comparable properties or ‘comps.’ Overall, this approach works best in a stable market with sufficient recent sales which allow for adequate comparisons. It also works well for properties like office buildings, retail properties, warehouses, and others.
This valuation method reviews past transactions of comparable commercial real estate properties. It considers property sizes, location, amenities, market conditions, and other things. Then, the sales comparison approach assigns a property value based on these factors. For example, if you want to purchase a Class B office building in a certain area, you would examine the sales of other similar Class B office buildings nearby.
While the method sounds simple, it hinges on finding similar properties as well as recent sales. As a result, difficulty finding enough comps for some properties to create an accurate valuation can be a disadvantage of this method. Also, unique properties or those that aren’t frequently sold (church buildings, government buildings, etc.) can be difficult to value with the sales comparison approach.
Income Capitalization Approach (or Income Approach)
As the name implies, the income approach focuses on the amount of income a property will generate for the new owner. This method applies to income-producing properties like office buildings, retail properties, and multifamily housing properties. What’s more, this approach works well for properties that have predictable expenses. Basically, in the income approach, an investor looks at the property’s income compared to their expected rate of return. Below are two common ways to determine a commercial property’s projected income.
One way for a real estate appraisal to assess a property’s income is through the Direct Capitalization method. In this method, an appraiser estimates the property’s potential yearly gross income while keeping losses and expenses in mind. This method works well when valuing income-producing properties.
By determining the annual NOI (net operating income), the appraiser can then estimate a purchase price that an investor might pay for that particular annual income. We calculate NOI with this formula:
NOI = Gross Income – Operating Expenses
The appraiser then estimates the capitalization rate (cap rate) and applies it to the NOI for valuation.
Capitalization Rate = Net Operating Income (NOI) / Current Market Value
For example, you purchase an investment property for $1M (Current Market Value) which creates $100,000 of annual NOI, then:
$100,000 / $1,000,000 = 0.10 (10%)
So, the Cap Rate would be 10%. Stated slightly differently, you would pay one-tenth of the investment property value’s total cost with the annual NOI.
Gross Income Multipliers (GIM)
Another way that a real estate appraisal calculates a commercial property’s value is with Gross Income Multipliers (GIM). This method works well when appraising properties that might not produce much income, but could still be rented, such as residential investment properties.
Basically, gross income is the total income a property generates before deducting operating expenses. Simply stated, GIM shows how the sale price relates to expected income. Below is a simple formula to calculate GIM:
Sales Price ÷ Rental Income = GIM
For example, if you purchase a $500,000 property that generates $70,000 in rental income, your GIM is 7.14.
$500,000 ÷ $70,000 = 7.14
GIM can also be alternatively expressed as:
Gross Income x GIM = Estimated Market Value
In the event that these other two valuation methods don’t apply to a property, the cost approach is useful. Some properties, such as government buildings, church buildings, schools, or even hospitals, aren’t necessarily income-producing properties. At the same time, these properties aren’t sold as often as office buildings, retail, or multifamily housing properties. As a result, it is more difficult to value them with either the sales comparison approach or the income approach.
In this method, the value is based on the cost to completely replace a property. The estimated replacement cost considers land, materials, labor, and other factors when determining a property’s value. A cost-based real estate appraisal might use one of several methods to estimate cost:
- Square-foot method – Multiplies the cost per square feet of a comparable, recently built property by the appraised building’s square footage
- Unit-in-place method – Estimates construction cost for individual building components; includes labor and materials
- Quantity-survey method – Estimates raw materials required to totally replace a property, their price, and the cost to install them
Another key factor in the cost approach is depreciation. In brief, depreciation is anything that lowers a property’s value. Specific things that lead to depreciation include outdated designs and features, functionally obsolete systems (like an aging HVAC system), an undesirable location, physical deterioration, and structural issues.
In general, the cost approach is used when a property has undergone significant improvements. Underneath the cost approach valuation is the assumption that buyers won’t pay more for an upgraded property than they would to build a new, similar property. One major disadvantage of this method is that it focuses on the cost of a new property. As a result, it may not take into account upkeep costs associated with an older property.
Build a Solid Portfolio with CXRE
Regardless of the chosen valuation method, every investor wants to get a solid deal for their money. If you’re interested in commercial properties—office buildings, medical facilities, industrial warehouses, retail developments, or land—in Houston, DFW, San Antonio, or elsewhere in Texas, contact us today.
Our team of commercial real estate professionals knows the various markets and submarkets. And no matter what level you’re at, we can help. We can help you expand your existing investment portfolio. Or we can help you purchase your first commercial property.