Commercial Real Estate Valuation

Commercial real estate valuation is the method of determining the value or worth of a commercial property using various methodologies and personal expertise.  Commercial properties are those real estate properties used for income generation or business purposes, not residential ones.

The valuation of properties gives buyers and sellers the realistic market value of the commercial property. It helps in understanding the pricing. These valuations help evaluate sales, financing, investments and mergers and acquisitions. The process ensures that the transaction is based on accurate reflections of the market and that it is fair to the involved parties.

Commercial real estate valuation is the estimation of the market value of a property that is not used for residential but business purposes. These assets are created with the aim of generating income through lending or selling. 

Certain primary factors influence the value of a property. They are demand, utility, transferability and scarcity. These factors become the foundations of commercial property valuations. However, individuals also consider acquisition price, property's cost of maintenance, and legal, economic and social environmental factors. 

Apart from the above-mentioned factors, local market activity, local real estate activity and market stability are some of the factors that influence the valuations. This is because local markets with limited real estate and local real estate activity that has a smaller number of deals tend to result in increased prices. A market with limited deals would most probably not have much data for comparison. Hence, stable markets are better at providing accurate valuations. 

Commercial property evaluation helps investors understand the cap rate, which is the annual return an investor can expect. Evaluation reveals if there is any debt service involved, which is the funds required to service a loan for particular periods. Similarly, it reveals the gross rent multiplier, which is a metric that tells us the property price ratio to the annual gross rental income. The estimation also reveals how much an investor has to pay per square foot and the return on investment they get after all expenses. 

Given below are some of the most common methods of evaluation. 

#1 - Income Approach  

It is a method used to estimate properties such as office buildings, rental complexes and shopping centers. It estimates the potential income a property can generate after adjusting operational cost, vacancy and future income streams. There are two methods implemented under it. First is direct capitalization. It calculates property value through the calculation of the annual generation of income. This is then divided by the cap rate to reflect the investor's desired rate of return. The second income approach method is the discounted cash flow method.

The method projects future cash flows from the property over a given time and discounts the value back to the investor's desired rate of return.  The discount rate is concerned with the risk associated with the investments. The formula for the income approach is the net operating income or, in short, the NOI divided by the capitalization rate or the cap rate. They are also known as income capitalization methods. 

#2 - Sales Comparison Approach  

The sales comparison approach uses property sales information to estimate the value of yet-to-be-sold assets.  They are used in cases where sufficient market data exists. The price comparison is done for similar properties in the area or the neighboring areas that have been recently sold. Adjustments are made taking into consideration the size, location, condition and date of sales. This method is not practical in cases where properties with unique features are rare in the market. 

#3 - Cost Approach  

The cost approach is a type of commercial property evaluation technique that separates the cost of the building from the land it is located. The value is estimated through consideration of the sale of similar properties, the addition of replacement costs, age, size of the building, their features etc. It helps the investors not pay more for an existing property when a similar property with the same utility can be built with the estimates. It calculates the cost to construct a property by subtracting the depreciation and adding the land value. The method is helpful in calculating property values that have unique features where there is not much comparable data available. 

Let us look at some of the examples to understand the concept better.

Example #1

Imagine Dan is a small business owner who wants a rental space to open a boutique for his clothes business. He is interested in a small space but the price quoted was huge. The seller justified the price by stating the location value and the amenities, such as water and road facilities, as reasons for the price increase.  

Dan, however, was not convinced, instead of opting for complicated methods. He used a commercial real estate valuation calculator to make a decision. The commercial real estate valuation calculator considered factors such as the age of the property, area, and gross building area to conclude. He also used the sales comparison approach to determine the value. His research found that the property value was indeed inflated as similar properties were sold at a much lower rate. Evaluation of the value helped Dan save a lot of money. 

Example #2

An article on the future of commercial evaluation

The article from Propmodo talks about the influence of machine valuations in the commercial property valuation field. Although automated valuation techniques have made great progress, they still find it difficult due to complex valuation factors. They include expenses and lease terms that are not publicly available.  The field lacks structured data that the algorithms can derive conclusions from. 

This highlights another challenge in the evaluation process. Human expertise is subjective, but unfortunately, automated algorithms are also at the beginning stages. This, however, does not disprove the fact that the field is highly profitable.  

Given below are some of the reasons that highlight the importance of commercial real estate evaluation 

• It helps the seller accurately value their property and not make a loss due to incorrect estimation. It could also backfire if the estimation is inflated. The pricing will not attract buyers.  
• It helps buyers understand how the property is priced and if they are paying more than fair market value.  
• It facilitates price negotiation where an opportunity is given for sellers to make a profit but not at the cost of making a loss for buyers.  
• It helps investors make better decisions through the evaluation of the prices to make investments.  
• It lowers buyers' and investors' risk of buying into a low-valued property. Commercial real estate valuation services can help individuals in finding the best choices.

Key challenges that are associated with property valuations are given as follows. 

• The availability of quality data is essential for price comparison in certain cases.  
• The collected data may not reflect the future or current market conditions, producing inaccurate results.  
• Stable markets are good sources of data, and if the markets are volatile, then accurate predictions may not be possible.  
• The valuation is not always based on proven methodologies. They are also subject to the opinion of the buyers, sellers or investors, and commercial real estate valuation services providers.  
• Investment sentiments can be a huge factor that influences market prices. 
• Future projections may not always be accurate as market conditions and other factors can come into play over time.