Appraisal Valuation Methods You Should Know For Commercial Real Estate
By Ed Rogan, Owner, Co-Founder
Determining the value of a commercial property is an integral component to the success or failure of a commercial real estate deal.
It doesn’t matter whether you’re working in multifamily, self-storage, retail, or office- as an investor, it is an absolute necessity that you understand how much you should pay for a property, or how much you should let it go for. Doing anything else risks leaving money on the table, or taking big losses.
If you’re new to the game, or just need a refresher, read on to learn everything you need to know to get started valuing commercial properties.
1. Market Value vs. Market Price
Market price and market value are separate concepts, but they both work in concert to influence each other.
The market price refers to the amount that a serious buyer is willing to pay for a given property, as well as what the seller will accept. The transaction in question determines the market price, which may then go on to affect the market value of sales in the future. The price is determined by supply and demand in the subject real estate market, the current condition of the property, as well as "comps" or what similar properties have sold for without adding in the value factor.
Market value is the opinion of what a given property would sell for based on the characteristics and features of that property, within a competitive market. Factors that affect market value include the current state of the real estate market, housing stock, housing demand, and what comparable properties have sold for in the recent past.
The primary difference between market value and market price is that the expectations for the market value may be radically different for buyers and sellers, while market price is not based on expectations, but what someone will actually pay. Value has the potential to create demand, which can positively affect price, but without the demand function value by itself cannot influence the price of a property.
As supply rises and demand goes down, price drops and value has little to no influence. As the supply goes down and demand goes up, prices will rise and value will have an influence on the price. Market price and market value have the potential to be equal within a balanced market.
2. Market Data/Comparable Sales
The Market Data/Comparable Sales or “Sales” Approach, is a real estate appraisal method that compares a subject property with other similar properties that have recently sold. This method looks at the effect that characteristics and features of the given property have on its overall property value.
Benefits of Using Market Data
Better Decision Making
Unless you have a clear view of the market, you will not be able to make the right decisions when it comes to buying and selling commercial properties. While time in the market is more important than timing in the equities markets, short term decisions can have a tremendous impact on the success or failure of your CRE investments.
If you're able to see the dangers in a particular market, you can dramatically lower your risk of falling prey to them. Market data tells you how hot or cold a market is, and can help prevent you from buying into markets that are on the decline, or that have the potential to drop due to market forces.
Understanding the correct property valuation before buying or selling is a significant portion of profitability in commercial real estate investments. Uncertain valuations can lead to paying too much for a property or asking too little during a sale, both of which will diminish your long term profitability. Conversely, if you understand the right valuation, you can scoop up undervalued properties and boost your returns.
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Market Data Factors
The old adage "location, location, location" is doubly true when it comes to commercial real estate. While you can change and improve many aspects of a commercial property, you cannot change the location. Market data will allow you to pick the best locations in which to invest or help you get out before a downturn.
The size of a given lot will determine how profitable the property is, as well as the potential appreciation value of the land.
In a similar vein to lot size, the average square footage for shows how much profit you can generate from the property. When acquiring a commercial property you want to make sure you differentiate between rentable square footage and total square footage.
While aging is fantastic for fine wine, it is not so good for commercial properties. A new property within a market with older properties can be good or bad- in some cases you may fill a market niche that is going unmet, in others you will be asking for rents above what the average tenant can pay- be sure to look carefully at the average of comp properties in your desired market.
Type of Construction
The type of construction can give you insight into whether or not a property will be filling a vital need for the community. For instance, if it is a hot, growing area new construction will do much better than a declining area where older, Class C and B buildings will be in demand.
Interior Layout and Physical Features
When looking at market data you need to take into account the interior layout and physical features of a property. Unique features like movie theaters, yoga studios, or extensive gym facilities can be attractive for renters as well as profit centers, but they can also be a liability, and sufficiently unique features have the potential to throw off comp data.
Building Sales Patterns
Sales patterns can give you a look into when buyers- usually other investors- are jumping in and out of markets. This activity alone will not tell you to buy or sell, but it can give you a feel for other players in the market, and you can use that as an impetus to look deeper.
3. Cost Analysis Approach
The Cost Approach is another way that investors and developers can appraise a commercial property. It is based on the belief that a buyer will not pay more for a product than they would for the same or a similar product with the same utility levels.
Benefits of Using Cost Analysis
The Cost Approach is best used with new properties, when the property is at its peak. This allows us to know costs and the property itself will have little to no depreciation, since the Cost Approach does not use property comps, it is particularly effective when determining the value of a special or unique property type that does not come on the market often.
Here are a few of the variables used within a cost analysis.
In order to perform a rental property cost analysis there are a few things you need to collect, including:
- The purchase price
- The cost of any "make-ready" repairs
- Monthly market rents
- Homeowners Association fees
- Utilities not paid by tenants
- Interest rate (if it is a financed deal)
- Down payment percentage (again, if it is a financed deal)
Cost Analysis Methods
Better Decision Making
The costs of constructing a multi-family property in San Francisco are radically different than the costs in Omaha. Be sure to take these into account when creating financial projections, and put room in your analysis for cost overruns caused by material shortages, project delays, labor issues, etc.
Construction Cost Indexes
These indexes measure the input prices paid by contractors for a fixed market basket of the labor, as well as the materials used when constructing a commercial building. Investors can use this to determine construction or renovation costs for a project.
When determining the value of a deal, you need to take property appreciation and depreciation into account. Assets will be more expensive in markets that are seeing great appreciation and those expected to appreciate even more in the future, and cap rates will be lower. Depreciation comes into play because you never want to be holding an asset that is losing value- this all ties into the broader market, and issues related to depreciation can be avoided by careful choosing of markets or submarkets.
4. Income Analysis Approach
Rather than looking at costs to determine the value of a project, you can analyze its income to see if it is a good deal or not. The income approach, also known as the income capitalization approach gives investors the ability to estimate property values based on income generated by the property. You find this number by taking the NOI or “Net Operating Income” aka the rent collected and dividing it by the capitalization or “cap” rate.
Benefits of Using an Income Analysis
The Income Analysis is effective for commercial investors because rather than looking at the costs involved, it looks at the income generated by a property. As commercial properties are essentially businesses, looking at the income and the costs is a much better way to get an accurate assessment of the property.
How Income Analysis Works
The Income Approach operates similarly to DCF, or discounted cash flow, which is used in the finance field. It discounts the future value of rents by the cap rate. When investors use the income approach to evaluate a rental property, they look at the amount of income generated by the property to determine how much the property will sell for in the current market. It also tells investors whether or not they will profit from the property. Additionally, lenders use this data to determine whether or not to lend capital to developers and investors for property acquisitions.
The first step is for investors to use market sales of comparable properties to determine a cap rate. For instance, take a 6-unit apartment building in Alameda County, CA. An investor would look at the recent sale prices of similar properties in Alameda County. Once the investor figures out the cap rate, they can take that number of divide by the rental property’s NOI.
Take a property with a net operating income of 1 million, and a cap rate of 7%, you come up with a property value of $14,857,143.
Potential Future Income
Investors can use the potential future income of the property when calculating the Income Approach, and thus get a read on how the property might be valued in the future, or if certain rent/revenue targets are hit.
As we mentioned earlier, the cap rate is integral to calculating the Income Approach. Cap rates are used to indicate the expected rate of return that will be generated by a commercial property. It is calculated by taking the property’s expected net operating income and dividing that by the property’s asset value, and is expressed as a percentage, like the 7% cap rate mentioned above.
Factors That Determine the Best Real Estate Valuation Method to Use
There are several contributing factors that help investors determine which appraisal strategy is best for the task at hand. Let’s take a look at some of the most critical.
Supply and Demand
When you are purchasing or selling a common property type, with many comparable sales, you are in the best position to come to an accurate valuation by using the market approach. In situations where supply or demand are constrained, like an area with only a few other multifamily buildings, or one with not many recent sales, it might be a better choice to use the income or cost approach.
Transferability refers to how easy it is to transfer ownership rights from one party to another. This is relevant to an appraisal because issues with transferability can dramatically impact the market value and eventual price of a property. Buyers and sellers do not want to deal with paperwork, and legal fees, so enticing them with a reduced valuation may be necessary when selling a property with transferability issues.
Local Market Activity
The overall trend of the local market can also lend itself to one strategy or another. In hot markets where rents are expected to rise by a significant amount you can use that to your benefit in your rent projections for the income approach.
On the opposite end of the spectrum, if a market is slow, with little new construction you would want to avoid using a cost approach since it is best used for new properties. Basically, let the market be your guide to determining the best strategy to utilize.
Local Real Estate Activity
As a rule of the thumb, the more real estate market activity, the easier it is to come to an accurate valuation. Think about it, if you’re looking to buy a multifamily property in a booming apartment market in downtown Chicago, you’ll have a much better understanding of what the price should be compared to buying a ranch in rural Idaho with one or two remotely comparable sales in the past year.
Basically, the more high-quality data the better, and investors can leverage data resources to get a leg up on the competition and find undervalued or underpriced assets.
Stable markets offer the greatest opportunity to come to an accurate valuation.
For instance, let’s say your local market is volatile, with boom and bust cycles similar to the North Dakota property boom during the Oil Boom in the 2000s. As demand skyrocketed in these areas prices would jump by multiples- a home that maybe once sold for 25,000 the year before might sell for 50k, 100k, even 250 to 500k.
Compare that with somewhere like the Bay Area, which saw increasing regular growth during that same period- the stable growth gives investors the ability to more accurately look into the future, and thus be more effective in their valuations.
The Keys to a Successful Appraisal Valuation Strategy
There are two keys to a successful appraisal valuation strategy. The first is matching your investment goals, property, and market to the right approach. Second is the quality and depth of your data- the better market data you have, the better your valuations will be. Digital tools and platforms radically changed the industry and if you are not choosing to use these advantages you will be at a significant competitive disadvantage in relation to your peers that harness these technologies in their valuation strategy.
The Penn Capital Way
At Penn Capital, a diligent, data-driven appraisal valuation strategy is an integral component of our approach to finding the right commercial real estate assets to create value for our clients. This laser-focus on finding value, and executing on a high level, alongside our hands-on management style of heavy renovation and aggressive lease-up has led us to generate an average internal rate of return in excess of market norms for our investors in the multifamily space.
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