How do you Calculate the Value of a Commercial Property?
Given how important real property assets are, understanding how the appraisal process works is a key first step in making various decisions about your real estate. How to calculate commercial property value will depend on the reason for the appraisal as well as the type of property being appraised and its value influences. Triggering events that would require knowing the value of your property include securing financing, estate planning, or tax issues. There are three main approaches used by appraisers to value real property investments, each with its own strengths and weaknesses.
How do you Determine Commercial Value?
Appraisers gather as much information about the property and market as possible before utilizing one or all three approaches to arrive at a market value. Given that each method provides its own unique value perspective, it’s common for appraisers to use a combination of all three to support a final value conclusion. The remainder of this blog segment will focus on providing the specifics of each method including when they’re most applicable, how they’re used, and how they compare to each other.
3 ways to Value Commercial Real Estate
In this post we’ll go over three of the most commonly used and effective appraisal techniques used in the industry which are the:
Direct Comparison Approach
Cost Approach
Income Approach
Direct Comparison Approach
The Direct Comparison Approach is based on the premise of substitution, or, that a rational investor will not spend more on a property than it would cost to acquire a similar one with the same utility and without undue delay. Therefore, the value of a property is indicated by the sales of similar, or comparable, properties in the market.
How do you know if a Sale is Comparable?
An appraiser will generally crossmatch key categories between properties to assess whether the sale is comparable or not. These categories include but are not limited to:
Location
Physical characteristics
Land use/zoning
Economic characteristics
It’s also important that certain information be known about each comparable property including the real property rights, financing terms, buyer/seller motivations, and market conditions.
How to do a Direct Comparison Approach?
The general process for conducting a Direct Comparison Approach (DCA) is
Researching similar properties which have recently sold
Verifying the data is accurate
Establishing the units of comparison (price per square foot or room)
Analyzing and adjusting the sale price of similar properties based on market data to account for variances between the subject property and the comparables
Reconciling the value indications into a value range or a single-point value
Adjustments for variances can be quantified by using paired sales analysis, statistical analysis, trend analysis, or cost analysis and can be percentages or dollar amounts. When quantitative data is lacking, a qualitative analysis is conducted; this rates the comparables as being similar, inferior, or superior to the subject; this type of analysis produces a value range that brackets the subject.
The DCA is commonly used as it best reflects the actions of buyers and sellers in the marketplace and is easily understood. However, the DCA also has some limitations; there must be sufficient comparable market data to produce reliable results; since sales are historic, they may not reflect current value in a quickly changing market; unique or special use properties are not suited to this approach.
Direct Comparison Approach Formula
The general formula for a direct comparison approach is as follows:
Where the variables denote:
Vx = comparable property
N = number of comparable properties used
A = variance adjustments
MV = market value
Cost Approach
The Cost Approach relates value to cost. It follows the same logic relating to the principles of substitution in that a rational investor will not spend more on a property than it would cost to get an equivalent one. Within this approach, the cost of new construction less any depreciation is added to the value of the land to reach a total market value.
When would you use the Cost Approach?
The Cost Approach is especially useful for valuing special-use or unique properties such as churches, libraries, or hospitals, or for those that do not generate income, as well as for new, or newer, construction, and for insurance underwriting.
This approach loses reliability in older properties or those that have undergone various renovations because depreciation can be difficult to estimate. Another limitation is the assumption that there is an availability of similar vacant land which may not always be the case, particularly within urban areas that are developed.
Cost Approach Formula
The formula for the cost approach is as follows:
Where the variables denote:
MV = market value
LV = land value
CN = cost new
DA = accumulated depreciation
Cost Approach Example
Let's suppose that a non-profit organization needs to know the market value of its property for Canada Revenue Agency reporting purposes. The property consists of a 5,000-square-foot, three-year-old building located on a half-acre in a rural area. Sales data indicates that the value of the land is $125,000. Construction cost data indicates that it would cost $150 per square foot to replace the building in the current market. Using the age-life method of deprecation, the age of the building is divided by the total life of the building, to arrive at the amount of deprivation. Assuming the building has a total economic life of 60 years and is three years old, the depreciation amount is 5% (3/60).
Therefore, the market value estimate of the property is calculated as follows:
Land value + ((Cost New) – (Depreciation)) = Market Value
$125,000 + (($150 x 5,000) – (($150 x 5,000)x 0.05)) = Market Value
$125,000 + ($750,000 - $37,500) = Market Value
$837,500 = Market Value
Income Capitalization Approach
Most commercial properties are purchased as investments, therefore, earning potential is directly tied to value. In the Income Approach earning potential is based on the Net Operating Income (NOI) and a market capitalization, or cap, rate. The NOI is the gross operating income less operating expenses. A cap rate is the rate of return sought by investors; this is usually based on the market sales of similar properties. Rents and expenses are also arrived at by analyzing properties of similar size, location, and utility.