Breaking Down The Major Methods of Commercial Real Estate Valuation
If you run an internet search for how to value commercial real estate, you’ll find articles and tutorials on various methods. For those new to real estate, the simplicity of the valuation concepts can often be misleading. For example, a capitalization rate (cap rate) approach is mathematically simple. Just divide the net operating income (NOI) by the cap rate and, voila, you have an estimate of the value of the property. For experienced real estate practitioners, however, coming up with a valuation for a commercial property involves much more analysis.
While an in-depth analysis of each of the methods below will be addressed in separate articles, we’ll provide a brief overview of each concept and then delve into some of the factors that make these concepts more challenging in practice than they initially seem to be. As a note, many sources of information on commercial real estate valuation include the Capitalization Rate and the Discounted Cash Flow (also known as yield capitalization) within a larger category of “Income Capitalization.” This article breaks them into two separate approaches in order to highlight the differences between them.
The cost approach is an estimate of how much it would cost to build the structure from the ground up (meaning from an empty piece of land) and includes the value of the land as well. With the cost approach, the logic is to determine whether it’s less expensive to purchase an existing property or to build a new property from the ground up.
There are two major methods of the cost approach:
- Reproduction method – this is the cost of rebuilding an exact replica of the existing structure using the same materials, construction methods, condition, etc.
- Replacement method – the cost of rebuilding the structure with new materials, construction methods, and design.
While the logic is sound, this method doesn’t account for the additional effort of development and construction involved in building a property from the ground up. It also doesn’t account for the long-term cash flow potential of a property.
Sales Comparison Approach
Comparisons to market factors are one of the most important inputs to any valuation method. In fact, sales comparisons are usually the source of information such as cost of reproduction (discussed above), current market capitalization rates, loan-to-value ratios, and others.
The sales comparison approach involves analyzing other properties in the market that have recently sold. The list below is not exhaustive, but lists some of the major components discovered during the comparison analysis:
- price per square foot
- price per unit (multifamily)
- price per key (hospitality)
- capitalization rate (what cap rate did other properties sell for)
- physical condition
- income and tenant profiles (credit quality of tenant, stability of cash flows, etc.)
The more similar the comparable properties in terms of type, location, use, condition, etc., the more confident an analyst can be in the metrics used to value the subject property. Once the characteristics of the subject property are compared with those of the comparable properties, adjustments are made to reflect any attributes that are either more or less favorable for the subject property and then a final determination of value is made.
The sales comparison is a great way to determine how the market values properties that are similar to the subject property. However, like the cost approach above, the sales comparison method doesn’t capture the long-term cash flows an investor can expect during the hold period of the property.
Capitalization Rate Approach
It’s common to hear real estate professionals refer to what the property “traded at” by either citing the cap rate or the price per square foot that a property sold for. The cap rate is one of the most used methods of property valuation in both the lending world and for initial analysis of an intended acquisition.
The formula for the cap rate is to divide the net operating income (NOI) of the property by the capitalization rate (cap rate). The resulting number is the approximate value of the property based on the expected cash flow during the first year of ownership, often called the “1-year forward NOI” (the reason the 1-year forward NOI is used rather than the trailing 1-year NOI is that the return for the buyer of the property is based on future cash flows, not the past cash flows).
The cap rate method is a valuable tool to use when attempting to estimate the current market value of a property. However, this method is most valuable when the cash flow for the property is stable and relatively certain. For example, if attempting to value a building with little to no NOI, the accuracy of a valuation using strictly a cap rate approach would be suspect because a stabilized NOI is not known. In this situation, practitioners usually use a price per square foot or discounted cash flow approach to account for factors such capital improvements for neglected properties, downtime and tenant improvement costs for vacant buildings, etc. These costs, when added together, could have a significant impact on the returns an investor achieves during the hold period of a property.
Discounted Cash Flow Approach
Each of the preceding valuation concepts have merit in different situations, but they also have the same drawback. Each one (cost approach, sales comparison approach, and capitalization rate approach) estimates the value of a property at a specific point in time.
In order to understand why valuations at a specific point in time are a drawback, we first need to understand how real estate investors measure the return they will achieve over the hold period of a property. If an investor holds a property for ten years from purchase to sale, the overall return will be a combination of the cash flow from each of the ten years of ownership in addition to any difference between the purchase price and the sale price at the end of year ten.
So the cost, sales comparison, and capitalization rate approaches fail to account for potential changes in the cash flow or value of the property over the hold period of the property. For example, if an investor knows that in year four of the hold period, a major tenant is going to vacate the property and cause a significant decrease in the property’s cash flow for a period of time, this will negatively impact the overall return the investor achieves. The only valuation method that captures the future performance of the property is the DCF method.
The DCF method involves predicting the future cash flows over the estimated hold period of the property, including the annual cash flow and the profit at the time of sale. Many practitioners find that the practice of attempting to accurately predict revenue, expenses, and the future value of the property at the time of sale forces them to think more deeply about long-term risk factors, management, quality of tenants, and trends in the real estate market.
While not perfect (because nobody has a crystal ball to predict the future), the DCF method is preferred by investors due to the fact that the method better matches the reality of the investment than the others discussed above. For best-in-class DCF calculations, ARGUS Enterprise software helps top CRE professionals value property in the quickest and most accurate way possible.
Outside of the three most common forms of commercial real estate valuation discussed above, more niche methods of valuation come into play. Value Per Door breaks down valuation into a simple tally based on the number of units, primarily used for condos and apartments. Gross Rent Multiplier (GRM) is a method that compares an asset’s potential valuation by dividing the price of the property by its gross income over the asset’s lifetime. GRM can be an effective way to evaluate value-add assets, where there is a low price relative to the property’s income potential. Finally, there’s cost per rent-able square foot, which combines a tenants usable space with the building’s shared space, then comparing that number to the average lease cost per square foot. Valuing a building based on cost per rent-able square foot is a preferred method for high-end assets with top of the line finishes, a premier location, or both, as the value reflects what can be charged in rent to yield returns.
Choosing the right valuation method is like just choosing the right tool for the job. Most of the decision is decided on a case-by-case basis, based on the best information available. With the varying subjective methods and information, asset appraisal in the world of commercial is part formula, part art form. In the end, most appraisers don’t limit themselves to one method, instead taking an average of two or more methods; in addition to these methods, stress testing is also an important component of valuation. Learning what goes into each appraisal decision will help shine a light of the $8.9 trillion global commercial real estate market.