The Life Cycle of a Commercial Property Valuation
Despite the wishes of most real estate professionals, the accurate valuation of a property doesn’t just drop on their desk or appear in an email. It’s often a long and involved process requiring physical visits and inspections of a property, detailed analysis of income and expense performance, the review of the rent roll and each lease, and then the modeling and adjustments that must be made to accurately account for the unique characteristics of each given property.
This article will take a very high-level look at the process involved in reaching a valuation on a commercial real estate property. The process as laid out below is certainly not the only path that can be taken, but it does happen often enough and I’ll indicate where the process could be substantially different in some cases, if needed.
The steps in this section are not linear, but require an iterative process of review, research, and modeling that could go through numerous cycles before an analyst feels comfortable in the final product. So keep in mind that just because one step is listed before another doesn’t necessarily mean that you can’t revisit a previous step if required.
Initial Introduction to the Property
This is probably the step where the most variation exists. If you’re an appraiser or consultant, the introduction to the property will typically come through a client as an engagement. If you’re a broker or acquisition analyst, there are multiple ways you may come to know of the property, whether that’s an owner approaching you, you actively canvassing for potential properties, or public listings. For simplicity, this article will take the perspective of an acquisition analyst moving forward, though the steps would be similar for most activities.
“Back of the Napkin” Valuation
Once a property is on your desk, the best approach is to do a quick “back of the napkin” valuation to make sure the property is even somewhat within your area of interest. In this step, the analyst should use their local knowledge to ensure the metrics used (cap rate, NOI, lease rates, etc.) are realistic for the property and submarket. Assuming the property is still of interest, the analyst should move to more in-depth research.
Initial Collection and Review of Information
If the property passes an initial interest test, the next thing the analyst should do is review more detailed documents, such as the property’s financial statements, rent roll, market analysis, and physical inspection, if available. If these documents are not readily available, the analyst should request the information from the seller. Often a non-disclosure agreement is required by the seller at this step.
After the property documents are thoroughly reviewed, it’s usually a good idea to physically visit the property and get a better feel for the location, the condition, and ask any questions of the seller that were unclear or need further elaboration. This step can often lead to a better understanding of the abstract financial statements and rent rolls by providing a context for how the property is operating.
For example, let’s say two tenants occupying the same square footage in different spaces in the building are paying different rates for their space. At first glance it may not be clear why the difference in rates for the two tenants exists. But a visit to the building and visually inspecting each space shows that one tenant has a great view from their space while the other tenant does not. Or perhaps one space is oddly configured for some reason while the other space is normally configured. The small differences can bring into focus any anomalies that may have appeared within the financial statements themselves.
Construction the Valuation Model
It’s usually at this point that the analyst has gathered enough information and has gained enough of an intuitive feel for the property that they can begin developing a more detailed financial model. The details of model development are beyond the scope of this article, but should include not only the property information as given, but also any assumptions about operation that may be different from current or advertised performance.
This step also often requires the analyst to take a longer-term view of the prospects of the property and ask themselves questions such as:
- What is the likelihood that the current tenants will renew
- Given the market’s direction, what will growth and rental rates be in the future?
- What future physical maintenance will be required over the hold period?
- Should any of the current expenses be increased (if the property has been self-managed by the owner and the management fee is below market, for example)?
- Or is there a way to make the property more efficient by decreasing expenses?
- Given this location, can we expect a premium on sales price at the time of future sale or a discount (depending on the market trends in this particular submarket or location)?
While there are no definitive answers to these questions, they do force the analyst to consider any future impacts to the property that are not included in the prospectus or current performance.
Revisit Any Prior Steps
Often the construction of the model and the questions that arise will lead to additional analysis. That could mean again reviewing the financial statements or rent rolls for anything that could have a potentially negative impact, re-inspecting physical spaces and components (machinery, elevators, façade, etc.) of the building to determine the likelihood of future capital expenditures, or speaking directly with tenants to determine what their future intentions of occupying the space might be.
The above steps are by no means comprehensive, but rather provide a loose road map to be both as efficient and as effective as possible when valuing a commercial property. The last thing you want to do is spend two days pouring over financial statements and rent rolls and constructing a detailed model only to find out that the property offers nowhere near the returns your firm requires. Spending a little time upfront to quickly determine if the property is even in the ballpark can save you a lot of time down the road. Likewise, a physical inspection that reveals significant deferred maintenance that would eat into any revenue and profit in the future could rule out the potential for that property to be acquired by your firm.
The many nuances involved in the valuation process will become more intuitive over time as the analyst gains more experience (and often wastes a lot of time on some properties early in their career in order to learn these lessons). The important thing to remember is not to go too deep on any one component until there’s a general idea of the other components. This approach will often prevent unwelcome surprises from popping up after a lot of work has already been done.