Property valuation is an important piece of the commercial real estate transaction puzzle. But how exactly does it work?
There are many elements at play when it comes to commercial real estate valuation, each of which depend upon specific property characteristics, data points, and external market conditions. In this post, we’ll take a look at the property metrics that matter most, along with the three most common methods that appraisers use in determining CRE property value.
The Metrics that Matter
A property’s estimated value takes into consideration a variety of key data points, in addition to current market conditions and political and social trends. The four primary elements of property value are as follows:
- Demand: the desire or need for ownership supported by the financial means to satisfy the desire.
- Utility: the ability to satisfy future owners’ desires and needs.
- Scarcity: the finite supply of competing properties.
- Transferability: the ease with which ownership rights are transferred.
An accurate appraisal depends on the methodical collection of the commercial real estate data points that influence these elements and characterize a particular property. Metrics of particular importance include capitalization rate, net operating income (NOI), rental rate, lease terms, TI allowance, and rent escalations, each of which play a key role in the appraisal methods outlined below.
The Methods Appraisers Use
There are three commercially recognized valuation models for real estate: the income approach (cash flows), the sales comparison approach (comparable market analysis), and the cost approach. The method or methods commercial real estate appraisers employ to determine a property’s value varies depending on the type of property in question.
The income approach is the primary method used to appraise income-producing properties like multifamily apartment complexes, office buildings, and retail centers. While this approach is considered to be the most meaningful and accurate gauge of CRE property value, it is also the most complex.
The first step in using the income approach is to determine a property’s NOI, or the revenue that a property generates minus necessary operating expenses. Determining NOI is often an exceedingly detailed process in which an appraiser creates an entire profit and loss statement for a property, factoring in details like projected maintenance expenses and vacancy rates over an extended period of time.
Once the NOI has been assessed, the appraiser will survey other similar-earning properties in the same area to determine the current market value of the property in question. Capitalization rate can then be calculated by dividing the NOI by the determined market value.
Finally, the appraiser divides the property’s NOI by its cap rate to arrive at a value estimate.
Because it takes into account so many essential metrics, the income approach is largely regarded as the most valuable and information-dense CRE appraisal method. But for the same reason, this method requires close attention to detail, as an incorrect assessment of any factor can dramatically alter the resulting valuation.
Although the income approach is generally perceived as the most comprehensive gauge of a property’s value, other approaches can be used to great effect in specific circumstances.
The sales comparison approach, as one might assume, is a way to determine market value by comparing a particular property to properties with the same or similar characteristics. Commercial real estate appraisers using this approach must select comparable properties, ideally sold within the last year and within the same market considerations, and take into account seemingly both major and minor considerations. This includes basic things like area and square footage, along with more nuanced aspects like quality of construction and property conditions. Accurately determining like properties and accounting for differences requires extensive research, knowledge of an area, as well as industry experience. The resulting valuation reflects the idea that a property’s value is worth the net value of all of its features, which can be helpful for particular kinds of property — for instance, a multi-condo property.
Appraisers can also use the cost approach method by evaluating the costs of creating a property exactly like the subject. This approach operates on the assumption that a reasonable buyer would not pay more for an existing property than it would cost to buy a comparable lot and construct a new building. This approach is useful when dealing with infrequently sold properties that do not produce income — i.e., schools, churches, hospitals, and government buildings. The least frequently used of the three appraisal methods, the cost approach requires an in-depth knowledge of construction and material costs.
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