How to Value Commercial Real Estate

How to Value Commercial Real Estate: A Comprehensive Guide

Valuing commercial real estate is a critical process that involves various approaches. Whether you are trying to market a property, put together a deal, or manage transactions, understanding how to accurately value a property is essential. Without this knowledge, it’s nearly impossible to effectively navigate the commercial real estate landscape.

Two Approaches to Valuing Commercial Real Estate

There are two main methods for valuing commercial real estate: the market approach and the income approach.

The Market Approach

The market approach in real estate is similar to how residential properties are valued. Agents often pull comps (comparables), such as nearby houses with similar attributes, to estimate value. For instance, a four-bedroom, two-bath home sold nearby for $325,000 might indicate that your similar home is worth around the same price.

In commercial real estate, the market approach is based on price per square foot. For example, a Class B office building in South Minneapolis might be valued at $140 per square foot. In the case of multi-family properties, you might hear, “These 20-unit buildings are trading for about $95 per door.” This approach gives a clear market-driven perspective on property values.

The Income Approach

In commercial real estate, the income approach is key, especially when guiding seller-focused clients. This method primarily focuses on net operating income (NOI), which represents the income the landlord earns annually. For instance, with a net lease property like a Walgreens location, the tenant covers all expenses, and the lease might span 10 years with options to renew.

To evaluate the property, we divide the NOI by the sale price to obtain the capitalization rate (cap rate). This is a straightforward way to measure return on investment (ROI) and assess a property’s performance.

How to Price Commercial Real Estate

To price commercial real estate, both the market approach and income analysis are necessary. For example, when pricing a retail building, you’ll start by examining the base lease rate. A storefront of 2,500 square feet leasing for $22 per square foot leads to a calculated NOI, which can then be divided by the sale price to determine the cap rate. This valuation process often involves detailed spreadsheet work rather than guesswork.

Challenges in a Changing Market

The real estate market can be unpredictable, especially during periods of economic fluctuation, like the pandemic of 2020. In such markets, buyers may hesitate to pay what sellers are asking. For instance, a seller might want $150 per square foot, but cautious buyers may only be willing to offer $130. This disparity requires brokers who understand how to navigate the challenges of a fluctuating market.

Seller Motivation

Seller motivation plays a significant role in pricing strategies. Some sellers want their property sold quickly, perhaps by the end of the year, while others are willing to wait longer. Understanding these motivations can help determine how the property is priced and marketed.

Conclusion

When valuing commercial real estate, it’s crucial to choose a broker who understands the data, has a clear methodology, and can formulate a strong disposition strategy. With the right approach, commercial real estate investments can be successfully managed and sold.

How to Calculate Commercial Property Value

Determining the value of a commercial property is a vital aspect of real estate investment. One common metric used in this process is the capitalization rate or cap rate, which is often misunderstood. The cap rate provides insight into the return on investment for a property, but its usefulness goes beyond simple comparison. Here’s a guide to building a more customized approach to calculating commercial property value.

Building Your Own Cap Rate

Instead of relying on market cap rates or comparing what others paid, it’s more accurate to create a cap rate based on factors specific to the property in question. This approach uses the Net Operating Income (NOI), along with assumptions from the debt market and the desired cash-on-cash return.

Step 1: NOI Calculation

To start, calculate the property’s gross operating income and subtract operating expenses to find the NOI. For example, if the property generates $750,000 in revenue and costs $200,000 to operate annually, the NOI would be $550,000. Most investors would stop here and apply a cap rate to this number to estimate the property’s value.

However, applying a generalized cap rate may not be accurate enough. Instead, factoring in debt and equity creates a more realistic picture.

Step 2: Financing Assumptions

When evaluating commercial property value, financing assumptions such as amortization periods, interest rates, and loan-to-value ratios play a key role. For instance:

• Amortization Period: A typical range is 15-30 years; let’s choose 25 years.
• Interest Rate: Assume a rate of 5.25%.
• Loan-to-Value Ratio: A loan-to-value ratio of 70% means the investor provides 30% equity.

Step 3: Cash-on-Cash Return

Investors generally seek a specific cash-on-cash return. Let’s assume the investor wants a 10% return. By factoring in debt and equity financing, the cap rate in this scenario would be 8.03%. The rate is derived from 70% debt and 30% equity, reflecting the typical financing structure in commercial real estate transactions.

Adjusting Assumptions

If the desired cash-on-cash return is lowered to 8.25%, the cap rate drops to 7.51%. Similarly, if the interest rate increases to 5.85% and the loan-to-value ratio changes to 65%, the cap rate adjusts to 7.84%. This method, known as the band of investment theory, ensures the property’s value is calculated based on real financial conditions.

Conclusion

Calculating commercial property value requires more than just comparing cap rates from similar sales. By using NOI, financing assumptions, and desired returns, you can build a cap rate that reflects actual market conditions and the specific investment. This customized approach will lead to a more accurate and reliable property valuation.

How to Calculate Price Per Square Foot on a Commercial Property

Calculating the price per square foot for a commercial property is straightforward. Here’s a quick breakdown using a 20,000-square-foot office building as an example.

Step 1: Determine the Property Size and Purchase Price

In this scenario, we have a 20,000-square-foot office building purchased for $1,000,000.

Step 2: Use the Formula

To calculate the price per square foot, use this simple formula:

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Price Per Square Foot = Purchase Price ÷ Total Square Footage

For this example:

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Price Per Square Foot = $1,000,000 ÷ 20,000 = $50 per square foot

Why Is Price Per Square Foot Important?

In the commercial real estate world, price per square foot is an essential metric for various reasons:

• Valuation: Banks, appraisers, and professional investors often use this metric to value commercial properties.
• Industry Standard: Outside of apartments, per square foot is a common language for transactions.

When you buy a 20,000-square-foot office building for $1,000,000, you’ll say you bought it for $50 per square foot. This is how both investors and industry professionals evaluate and compare properties.

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