Price Per Square Foot Valuation Method for Commercial Real Estate
Using the price per square foot (price PSF) to value commercial real estate is not one of the three formal valuation methods (cost approach, income capitalization, and sales comparison) as defined by the Appraisal Institute. Rather, it straddles the cost approach and the sales comparison approach to valuation. In the commercial real estate investment world, however, the price PSF is used heavily as a metric to quickly understand whether or not a property or piece of land is in line with the rest of the market.
This article will discuss the various ways in which price PSF is used, including the use case for the cost approach and the sales comparison approach to valuation. We’ll also discuss some variations of the price PSF concept, the situations in which price PSF is useful and those in which other methods of valuation will provide a better sense of property value.
How to Calculate Price Per Square Foot
A price PSF can be determined for any property type and also for raw land. However, professionals in the industry often refer to the price of a property by different metrics, depending on the type of the property. For office, retail, and industrial properties, the price PSF metric is common. For residential properties, a variation referred to as “price per unit” is often used, where “unit” denotes an individual apartment. Finally, for hotel/hospitality properties, investors often use the phrase “price per key,” where “key” denotes an individual hotel room. Each of these variations is useful if the comparison is apples to apples, meaning price per unit is compared to price per unit, price PSF compared to price PSF, etc. The formulas below show the calculation for each metric.
Price PSF = Property Value / Property Size (in SF)
Price Per Unit = Property Value / Number of Units
Price Per Key = Property Value / Number of Rooms
Different Applications of Price PSF
As mentioned above, a price PSF metric is used in both the cost approach and the sales comparison approach to valuation, though they’re used slightly differently in each case. In the cost approach, the price PSF indicates the cost PSF for building a property or the cost of a piece of land. Alternatively, in the sales comparison approach, a reference to price PSF usually indicates a sales price divided by the number of square feet of the property.
In practice, there are numerous ways in which a price PSF metric is used. It could signify the cost of renovation, the rate of a lease on a commercial property, or the amount of an expense the property incurs. Those experienced in construction and development can often get a feel for the cost of a property at different quality levels through an idea of cost PSF, providing a basis for evaluating the profit potential from a new development or a renovation. Because there are both formal and informal uses of the price PSF metric, you should always be clear about the context in which the price PSF is used.
Common Uses of the Price PSF Metric
In my experience, real estate professionals most often use the price PSF metric as a smoothing mechanism in order to compare value, cost, or operations across different properties. This is best illustrated with an example.
Let’s say an analyst is attempting to value two buildings. For our example, we’ll assume the buildings are both class B office buildings in the same submarket with similar tenant profiles and comparable rental rates PSF. However, one of the properties is 100,000 SF and the other is 150,000 SF. When the analyst looks at just the recent sales prices of the buildings, there seems to be a pretty significant difference in price.
However, when the analyst digs a little deeper and calculates the price PSF that each property sold for, the numbers are the same. Given that rental rates PSF are comparable at the two properties, an investor is paying about the same price PSF for income at each of the two properties.
In the real world it’s highly unlikely that the price PSF will be identical for both properties. There will almost certainly be slight differences in the circumstances of each property and there are certain economies of scale that large buildings benefit from that smaller ones do not, but this example was meant to illustrate the smoothing function that price PSF often plays in the valuation and comparison of commercial real estate.
This example also illustrates that similar properties in similar locations generally have similar abilities to generate revenue (meaning rental rates should be roughly equivalent). The same relationship will often show up when comparing the price of development, construction, or operating expenses for comparable properties. In most cases, comparable properties will have similar price PSF metrics. Any major deviations from the market norms could indicate properties with operational or management performance problems.
Limitations to Using the Price PSF
The example above assumed that the two properties were able to achieve comparable rental rates PSF from tenants with similar profiles (credit rating, lease terms, etc.). “Comparable” and “similar” do not mean “identical,” though, and even slight differences in revenue or expenses could lead to a range of potential valuations that is large. For example, a 10% deviation in NOI in one direction or another leads to a relatively large window of value. Therefore, the price PSF metric should be used in relation to more comprehensive valuation approaches such as the income capitalization or discounted cash flow approaches.
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.