Valuation Methods To Calculate Commercial Property Value
Nov 17, 2016
Have you ever wondered why a real estate property is worth what it is? Nowadays, we can simply pull out our mobile device and visit a number of web sites that can instantaneously give us their presumptions of a real estate property's value. But how did they come up with those numbers? It does not have to be a mystery. Understanding how a property is valued provides important insight that can affect the decision to buy, sell, or hold onto a property. Determining a solid value for a real estate property requires an in-depth review of current property information, income generation, operating expenses, and a detailed analysis of market data. There are solid methodologies at work behind making valuations mean more than arbitrary assumptions. The following are the 3 major methodologies which are utilized individually or collectively by real estate investors and professionals, such as real estate appraisers, to determine property value.
(1) Property - Sales Comparison Approach
This first method, relies on comparing the subject property to similar properties recently sold within a given market. With this method, property factors such as building and lot size, property condition, the age of the property, relative location, unit mix, and time of sale are important factors that need to be considered. If there are recent sales of comparable properties in the area that appear to be outliers (either significantly higher or lower in sales price), a closer look at the conditions of the sale need to be investigated. By using sales comparisons, an investor or appraiser can establish a focused range of where the subject property is likely to fall along a price range. Using this approach as the sole valuation method is best suited for evaluating residential properties and those looking to hold on to a property for a short period of time.
(2) Income / Capitalization Approach
This method is most commonly used in commercial real estate valuation. Properties such as apartment complexes and properties with one or more tenants can utilize this method. This approach of determining value is a reflection of a property's annual net income. The process of quantifying income into a value is called capitalization. Based on the income the property makes, that will determine the value of the property with this method. The more income a property brings in, the more the property will be valued. However, the caveat is the income approach can be limited by the accuracy of the property's income and expenses, which is use to derive the Net Operating Income (NOI) of the commercial property. The formula for determining a commercial property's value under the Income Approach is:
Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)
Due to the Cap Rate variable, the income approach "value" can be dependent upon the recent sales prices of similar properties around the area. Conversely, in the formula above, the Cap Rate number is reached by taking the Net Operating Income of the property and dividing it by the sales price (value). To find a property's value an investor or appraiser will usually insert an average cap rate of similar properties that were recently sold around the area. For this reason, the income approach can be dependent on the sales approach method because recent sales comps of similar neighboring properties are needed.
(3) Replacement Cost Approach
Determining market value of a real estate property using the Replacement Cost Approach emphasizes the principal of substitution and provides a cost based perspective. Instead of valuing the property as a whole, the present cost of the property's "parts" are used to derive value. To explain the cost approach simply, it is an estimate of the replacement value of a property based on the cost of the land the and value of the improvements made to the land. This method is especially useful when evaluating a property that is "one of a kind" a special-use property or when surrounding market data for a property is limited. Moreover, due to its controlled valuation method it can provide an investor or appraiser with a value that minimizes the effect of market fervor where real estate prices are surging due to demand exceeding supply. Appraisers will commonly take all these methods into consideration when they do their report and determine a property's value. For an investor, each method used individually or collectively, can provide valuable insight into whether the purchase value of the property is in line with the perceived value they place on the property - and ultimately whether to buy, sell or hold.