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
- Valuation Is Subjective
- Valuation Methods for a Commercial Real Estate Appraisal
- Adding Value to a Property
- Build a Solid Portfolio with CXRE
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 Is Subjective
Below, we examine several popular methods that appraisers use to provide commercial real estate valuations. However, it’s important to note that each of these methods is more of an art than a science. Though CRE appraisers follow specific guidelines to make their best estimates on a property’s value, they are just that: estimates. They are subjective.
To ensure you’re getting the fairest real estate appraisal, carefully consider the appraiser’s expertise and experience. Specifically, a real estate professional with ample experience with real estate appraisals in your specific asset class will provide the fairest estimate of the property’s value.
For sellers, an accurate property value is imperative, because it determines the sale price. An accurate real estate appraisal ensures maximum returns for the seller while also protecting the integrity of the deal.
Commercial real estate buyers also rely on accurate real estate appraisals to ensure a fair price for an investment.
As a buyer or a seller, you are entitled to ask the appraiser which of these methods will be used when determining the property’s value.
Valuation Methods for a Commercial Real Estate Appraisal
Below are several commonly-used valuation methods for a commercial real estate appraisal: the sales comparison approach or comparison method, the income approach, and the cost approach.
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 factors. Then, the sales comparison approach assigns a property value based on these criteria.
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. When using the comparison method, appraisers will examine data from similar properties in the same market. This data will help determine the real-time market values of the property.
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.
Additionally, the comparison method works best in a stable market. Therefore, it may not be the most reliable method during uncertain economic periods like we are seeing during the pandemic. Current data may skew the real estate appraisal, making it either unreasonably high or unreasonably low, depending on the market conditions.
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.
The income approach works best for properties that have predictable expenses. With this valuation method, an investor looks at the property’s income compared to the property’s expected rate of return.
Below are two common ways to determine a commercial property’s projected income.
One way for a real estate appraiser 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. By determining the annual NOI (net operating income), the appraiser can then estimate a purchase price that an investor might pay based on the potential for future 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, let’s assume 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.
In essence, 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 the above 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. Typically, they sell less often than 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.
With the cost approach 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, the cost of these materials, and the cost to install them
Depreciation is another key factor in the cost approach method. In brief, depreciation is anything that lowers a property’s value. The most common factors affecting depreciation include outdated designs and features, functionally obsolete systems (like an aging HVAC system), an undesirable location, physical deterioration, and structural issues.
Appraisers use the cost approach in instances where the comparison method or income approach are not helpful. Most often, the cost approach applies to special use properties, new build properties, or properties that have recently undergone significant renovations.
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.
Adding Value to a Property
There are several ways to increase a commercial real estate property’s value.
Technology updates or additions are an excellent example. Updating a property’s technology or capacity for technology makes it more desirable for tenants, increases the earning potential, and therefore increases the overall property value.
Renovations and updates are another way to increase the property’s value. Outdated spaces, appliances, and amenities tend to devalue a property. However, even a few updates could increase the property’s value.
Build a Solid Portfolio with CXRE
Regardless of the chosen valuation method, every investor wants to get the best bang for their buck. 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. No matter your available capital or your experience level, we can help you expand your existing investment portfolio.