Cost, sales comparison, and yield are the three main approaches to valuing commercial real estate. Learn more about these methods and other useful tools for valuing commercial real estate.
1. Cost approach
The cost approach is a type of commercial property valuation method that separates the cost of a building from the land it sits on. The process involves using the sales prices of similar properties to determine the value of the land, and then adding in the replacement cost of the building, taking into account the building's age, size, condition, and other features that may affect value. Investors may use this method when comparable properties are difficult to find, such as when a building has unique improvements or structural upgrades have added significant value to the land.
However, the cost approach has limitations: for example, if there are no comparable vacant lots, the estimates will not be very accurate.
2. Sales comparison approach
Also known as the market approach, this method uses recent property sales information to estimate the value of unsold assets. Looking at similar properties that have recently sold in the same area can help investors determine a building's fair market value. For example, a six-unit apartment complex can be compared to a similar building that recently sold a few blocks away. The appraiser will adjust the valuation to account for differences in age, size, and condition between the comparable properties.
The sale and purchase comparison method works best when there are many comparable properties available for analysis. However, if your property has unique characteristics that are difficult to find in the market, the sale and purchase comparison approach may not be the best commercial property valuation method.
3. Revenue approach
The income approach, also known as the capitalization method, estimates a property's value based on the income it generates. The formula for the income approach is Net Operating Income (NOI) divided by the capitalization rate (cap rate). The income approach is ideal for office, retail, and multifamily properties. However, it can be particularly complicated because investors must also consider factors such as the amount of income generated, how efficiently the property is operated, and the condition of the building to determine how much the asset will sell for in current market conditions.
Other Commercial Property Valuation Methods
In addition to cost, sales comparison, and earnings methods, investors might also consider some less-used valuation approaches, such as:
Gross Rent Multiplier (GRM): This metric indicates the ratio of a commercial property's price to its annual gross rental income. For example, if you purchase a commercial property for $1 million and have annual gross rental income of $140,000, your GRM is approximately 7.14 ($1 million / $140,000). This commercial property valuation formula is typically used to identify properties that are underpriced relative to their market-based potential income. Notably, it does not include vacancy rates or expenses. Value per Unit: Used primarily for multifamily properties, this commercial property valuation method focuses on the number of units in a building to determine its value. For example, a building with 20 apartments priced at $4 million would be valued at $200,000 per unit, regardless of the size of each unit. Cost per Rentable Square Foot: Rentable square feet combines the number of usable square feet with common areas that benefit renters, such as elevators and staircases. Investors can use this method to value a building by calculating the cost per rentable square foot compared to the average lease cost per square ft. For example, if a building has 10,000 rentable square feet and the average rental cost per square foot is $12 per year, a purchase price of $1.7 million would yield a gross rental yield of 7%.
Valuing Commercial Real Estate is an Art
Regardless of what approach an investor takes, accurate data is essential to any commercial property valuation. But remember, even the best data is still only an estimate. After all, valuing commercial property is an art, not a science. There is an element of subjectivity, and the best commercial real estate investors have honed their intuition to find the most attractive deal and the most effective valuation method for each transaction.