It’s important to know the fair market value for commercial property. This applies to all types of transactions, including those looking to sell, buy, or just enter a lease.
Additionally, knowing a commercial property’s value is crucial to make informed business decisions so you can invest well. It’s equally important to determine if the property’s price is reasonable in an open, competitive market where all parties approach the deal fair and with all the information they have.
There are many ways to determine the fair value of the commercial property. Each approach has advantages and disadvantages, depending on your investment and financial goals. The best method can be determined by personal preference and industry standards.
Consider all the options available to determine the fair market value for commercial properties to see which one best suits you.
1. Income Capitalization Approach
Income capitalization is a popular method of valuing commercial real estate properties. It determines a property’s fair value relative to the income it could generate in the current market conditions.
This method determines the property’s net operating income (NOI). First, it takes into account expenses such as staff, utilities, maintenance, etc. Then, it calculates its effective gross income, which is the income earned under current market conditions and occupancy rates. The property’s fair market value is then calculated by dividing the NOI by the current market capitalization rate.
Sometimes, however, the NOI of a commercial property cannot be determined. For example, if the property has been vacant for a long time or investors want more detailed results, this could be the case. When this happens, the NOIs for comparable properties will be used as projections.
2. Replacement Cost Approach
The cost approach is used to determine the fair market value for commercial real estate. First, it takes into account the current land value and the cost of rebuilding the entire property. Then, it subtracts the depreciated cost of the existing structure.
The replacement cost approach has a central feature that considers the property’s most profitable and efficient use. This can be problematic in areas where zoning laws may interfere. Furthermore, the cost approach advantage is that it uses current value and conditions. This makes it a common valuation method for tax assessors and lenders financing multiphase developments. It is also used to determine the market value or establish the commercial property’s worth for insurance purposes.
The replacement approach is often used in conjunction with the sales comparables approach to assist investors in deciding whether to purchase a property or construct a new one. Investors will generally avoid projects whose purchase or improvement costs exceed the value determined by the cost approach. Thus, this is the main drawback of the replacement cost approach; it doesn’t include income the property could generate if it was used as an income-producing asset.
3. Sales Comparables Approach
The sales comparables approach—or market value approach—is considered the easiest way to determine fair market value for commercial property. It relies on the recent area sales and/or listing of similar commercial properties. A value range is first established using comparables. Next, there is an adjustment for property age, state of repairs or upgrades, land-to-building ratio, tax rates in the area, land size, etc. All these are considered in relation to current market trends.
Unfortunately, this method has a major drawback: it doesn’t account for potential repair or maintenance costs, building expenses, and occupancy rates. Additionally, this method is sensitive to market activity. If area comps are too outdated, they won’t be able to provide an acceptable range that is in line with current market conditions.
However, brokers can now simplify comps and improve accuracy in today’s technology-driven environment with online platforms built on extensive commercial real estate data. These platforms also offer flexible, broker-oriented tools—such as commercial comparables or market insights based upon the most recent area sales—to determine the most accurate commercial property valuations.
4. Discounted Cash Flow Approach
Although the income, replacement, and sales methods are all reliable ways to determine fair market value for commercial properties at a given time, they do not take into account market trends and changing values over time. They also fail to consider the equity earned from the sale or transfer of a property after the asset’s holding period, which can be a significant source of income during the deal’s life cycle.
However, the discounted cash flow (DCF) considers the difference between the purchase price of the potential owner and the estimated sale price at the end of the holding period. It also considers the value of time (inflation, risk, and internal rate of returns), the net cash flow, tenants, lease terms, staff, and management.
Although the income, replacement, and sales methods are all reliable ways to determine fair market value for commercial properties at a given time, they do not take into account market trends and changing values over time. They also fail to consider the equity earned from the sale or transfer of a property after the asset’s holding period, which can be a significant source of income during the deal’s life cycle.
However, the discounted cash flow (DCF) considers the difference between the purchase price of the potential owner and the estimated sale price at the end of the holding period. It also considers the value of time (inflation, risk, and internal rate of returns), the net cash flow, tenants, lease terms, staff, and management.
Furthermore, real estate market fundamentals and trends are also considered here, which include occupancy levels, rent rate, and rent rate trends, new supply, and absorption of similar properties in the area.
5. Gross Rent Multiplier Approach
The gross rent multiplier (GRM), similar to the income approach, determines the value of commercial property. However, it uses gross rent rather than a property’s NOI.
This allows for discounting expenses such as maintenance, staff wages, and taxes. Unfortunately, this disregard for operating expenses is its biggest disadvantage. Nevertheless, it is why the GRM approach can be used in tandem with other methods to calculate the fair market value of commercial properties.
Another difference between the GRM and income approaches is the gross rent multiplier, which is a figure that replaces the standard cap rate. However, if there is no gross rent multiplier for the property, the gross rent multiplier for comparable properties in the same area will be determined.
6. Price Per Square Foot Approach
While not usually used to determine commercial real estate’s market value—such as the income capitalization or sales comparables methods, the price per square foot approach is a quick and easy way to evaluate or reject a potential investment opportunity.
There are three subtypes:
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The Pure Price Per Square Foot Approach
This approach is often used for office, industrial, and retail properties. It multiplies the property’s square footage by a predetermined price/square foot to determine a commercial property’s value.
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The Price Per Unit Approach
This method is primarily used for condominiums and apartments. It calculates the commercial property’s value by multiplying its price per unit by the number of units.
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The Price Per Key Approach
This approach is used in the hospitality industry to determine the market value of commercial properties. It involves multiplying the price per key by the number of guest rooms.
If a price per sq. foot, unit, or key is not available for any of the three options, an estimate can be made based on comparable properties in that area. Also, the price per square footage of the target property would be adjusted to account for details such as age, condition of repairs, and location.
Which Approach Is Best For You?
There are many ways to determine the fair value of a commercial property. Usually, you can find more than one method is used to assess the finest of details that might impact a potential deal.
One approach isn’t necessarily better than another—it really depends on what type of property you’re hoping to invest in. Investors and brokers should do their due diligence using at least two valuation methods that complement one another.
Ultimately, one of the biggest factors in determining the value of a commercial property is the current market. Even if you use market cap rates or sales comps to determine the value of the property, it is only worth what a buyer will pay. This is why some properties will sell for less or more than they are worth.
Thus, timing is everything.
