- April 9, 2018
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Whether you are looking to buy or sell a commercial real estate property, it’s obviously important to be very clear on its value. Value can be defined as the most feasible price the property could reasonably earn in an active, open, and competitive market when the transaction is approached in a fair and knowledgeable manner by both buyer and seller. There are three different approaches that are typically used to appraise a commercial property, and choosing the right method for your particular investment is essential to ensuring that it is priced correctly. Let’s take a look at these three approaches separately.
The Income Approach
Also referred to as the Income Capitalization Approach, this tactic is the one most commonly used in commercial real estate transactions. The value is established here by estimating the property’s income, using the capitalization rate (commonly referred to as simply the cap rate). The cap rate is essentially the net operating income of the property divided by its current market value (or sales price). An example of this might look something like this:
Take a property with a gross potential income of $500,000, subtract a 10% vacancy factor of $50,000 and you will be left with an effective gross income of $450,000. Subtracting from this the operating expenses of the property (we’ll say $150,000) will help you to arrive at a Net Operating Income (or NOI) of $300,000. Divide this by the cap rate (8%) and you will arrive at your fair market value price of $3,750,000.
The Replacement Cost Approach
Oftentimes shortened to simply The Cost Approach, this is a much more complex route of valuing commercial real estate properties. It first considers the value of the land on which a building exists (value without the inclusion of the building). It then factors in what costs would be incurred to build an exact reproduction of the current existing building and adds that number onto the land value. Lastly, the depreciated value is considered and the actual property value number adjusted accordingly.
The Market Value Approach
Sometimes called the Sales Comparison Approach or the Comparable Approach, the Market Value Approach is quite arguably the simplest method to determine the value of a commercial real estate property. This type of method compares the property in question to other properties of similar use and size which have been sold or placed on the market in the surrounding area. A range of value is established from the findings of the market research and from there the number is adjusted based on the physical characteristics of the property being valued. Factors that will likely be considered are discrepancies in the dates of the sale, age of the property, condition of the property, square footage of the actual building and size of surrounding land, location, land to building ratio, local tax policies, and other physical characteristics based on the importance they hold in the current market and the affect they have on the particular property being valued. Basically, this number is determined by what a purchaser is likely willing to pay in an open, fair, and competitive market at any given time. A buyer may put less or greater personal value on a property based on how it serves their needs, but this is an easy way to determine a baseline to begin negotiations between two parties.
Which Approach is Right for Me?
Now that you have a much clearer picture of each of these fundamental valuation tools, you may be wondering which method is right for your commercial real estate property. The short answer to that is that each of these modalities is valuable in its own right. For example, for a property that is located further away from similar properties, it’s going to be harder to determine cap rates and comparable selling prices, in which case the second method may make the most sense. If you have access to the data needed to determine the cap rate, the first approach will be effective. If you have a property where vacancy rates fluctuate (such as a multifamily building), this may not work out so well, in which case you might consider the third option of using comparables.
Looking for Commercial Real Estate in the Baton Rouge Area?
If you’re ready to sell your commercial real estate property or looking to invest, it’s so important to make sure that you are clear on a properties actual worth. Working with a professional can help you to avoid mistakes and pitfalls. At SVN |Graham, Langlois, & Legendre, LLC, our team of dedicated Advisors is here to make your venture a success. With over 99-years of combined experience helping our clients get the most value out of their real estate transactions, you can’t go wrong having us on your side. Take a look at our database of commercial properties, and contact one of our team members today!