Commercial Property Comparative Analysis
Comparables, or “comps” as they’re usually referred to by real estate professionals, provide the foundational information for commercial real estate valuation. Without good comps, the analysis process for a property becomes extremely difficult and risky. Below we’ll discuss what a comp is, two categories of comps, how to choose good comps, and then how to apply the information obtained from the comps analysis to the subject property.
What is a Comparable Property?
In residential real estate, the goal of the appraiser is to find properties that are comparable to the property under consideration. In this case, “comparable” means finding properties that have recently sold with characteristics (such as size, location, and quality) that are as similar as possible to the subject property. The appraiser then makes adjustments for variations between the properties and determines a final estimate of value for a home.
In commercial real estate, however, what we define as “value” is more complicated. As with residential properties, commercial properties are valued based on comparisons with properties of similar physical characteristics, but an added layer in commercial is to value the property based on the income the property is or can potentially generate in the future. Due to this additional factor, there are a few metrics used in commercial real estate valuation that are not used for residential properties.
Types of Comparables
Before we jump into choosing and using comps information, it’s helpful to define the different categories of information we’ll be discussing. These two types are often referred to as sales comps and leasing comps. Sales comps are used to gain information about market cap rates, price per square foot, or price per unit of properties that have recently sold. Leasing comps are used to better understand current market trends in lease rates and terms, occupancy, and absorption for similar properties in the area.
While sales comps help owners better understand the market value of properties they’re considering purchasing or selling, leasing comps help them to better understand how to operate properties under ownership. The details of the different methods of valuation and lease analysis are discussed in other Insights papers, so we won’t go into detail on each one of them here, but it would be a good idea to get familiar with the nuances of those concepts.
How to Choose Good Comps
Choosing good comparable properties in commercial real estate can be a complicated process. Similar to residential real estate, the more similar the properties are in location, quality, size, etc., the more confidence the analyst can have in the estimate of value. But given the wide range of factors that need to be considered in evaluating the income potential of a property, how do we decide what makes a comp “good?”
A good first step is to find properties that have either recently sold (for sales analysis) or where leases have recently been executed (for leasing analysis). The reason the time component is stressed before the location component is because market conditions change over time, sometimes rapidly in one direction or another. If the building next door sold five years ago and the market has changed significantly in the time since the sale, the metrics of the sale are probably not relevant to current market conditions. The same concept applies to leases that were signed in the distant past. They probably do not reflect current market conditions and should not be used to determine current pricing.
The next step is to find properties that are “locationally” similar. This usually means properties in the same submarket or within proximity to the subject property. For properties that are more unique or where there are very few transactions in the immediate area, the analyst may have to expand their search area, but should be cognizant of finding submarkets that are similar to that of the subject property and should be prepared to make adjustments to reflect differences in the markets.
Not only are there different use cases for commercial properties (office, retail, industrial, residential, etc.), there are also different physical qualities and characteristics that need to be considered. For example, a new luxury residential building in a market should not be used as a comparable for a four-story walkup residential building in the same market. Likewise, a class A office building in the central business district of a major metro area should not be used as a comparable for a class C office property in the same submarket.
The last major item we’ll discuss in this article is the income that the property is generating. Even if two properties that are similar in transaction date, location, and physical characteristics are being valued, if the source and risk of those income streams are different, the properties may not be good comparables. For example, if a property that recently sold had major occupancy problems (perhaps it just lost a major tenant) and was sold quickly to avoid default/foreclosure, it would be valued very differently than a property that is fully occupied with a strong tenant with a long-term lease. Because the income and risks associated with that income are different, the sales could have vastly different metrics such as cap rate and price per square foot.
The list above includes the major components that an analyst should consider, but it is by no means all-inclusive. The nuances involved in both identifying comparables and making adjustments to ensure similarity can be complex and subjective. The more an analyst understands about the underlying situation of both the subject and comparable properties, the better the analyst can apply the findings to the subject.
How to Apply Comps Information to the Subject Property
Once the analyst has identified a sufficient number of comps (three to five is a good rule of thumb), the next step in the process is to translate the transactions that occurred in those comps to the activities in the subject property. If the analysis is for the purchase or sale of a property, the analyst needs to understand the operational circumstances of the comps, including the stability of cash flows, amount of physical repairs or maintenance needed to improve the property, and whether or not the transaction was a distressed sale. For a lease analysis, factors such as the credit quality of the tenant, the length of the lease, and the terms (free rent periods, amount of tenant improvements, etc.) need to be understood.
After careful evaluation of the factors above, the analyst should make assumptions about the operation of the subject property and perform a valuation estimate using one or several of the major valuation methods for commercial real estate. For methods such as income capitalization and price per square foot/price per unit, the current operation of the property is the focus of the analysis.
For a discounted cash flow approach, however, the analyst must project the performance of the property into the future. The length of the projection is determined by the expected hold period of the property. This look into the future requires an analyst consider not only current conditions, but expected changes in both real estate market fundamentals and the operating performance of the subject property itself.
Comps don’t provide the value of a property, but they do help to provide the inputs that are needed for comprehensive valuations of commercial real estate. Understanding real estate market trends and macroeconomic factors are also part of a valuation analysis. Often, transactions in comparable properties, when viewed in relation to real estate and macroeconomic factors, can provide a good indication of market movements or the sentiment of investors in that market.
About the Author
Josh Panknin is a Visiting Assistant Professor of Real Estate at New York University’s Schack Institute of Real Estate and an adjunct professor in the school of engineering at Columbia University. Prior to academics, Josh was Head of Credit Modeling and Analytics at Deutsche Bank’s secondary CMBS trading desk where he helped develop and implement automated models for valuing CMBS loans and bonds. He also spent time at the Ackman-Ziff Real Estate Group and in various other roles in research, acquisitions, and redevelopment. Josh has a master’s degree in finance from San Diego State University and a master’s degree in real estate finance from New York University’s Schack Institute of Real Estate.