Commercial real estate valuation methods and when to use each

The fundamentals of commercial property valuation

Commercial real estate is valued using four primary methods: the cost approach, the sales comparison approach, the capitalization rate approach, and the discounted cash flow approach. Three further methods, value per door, gross rent multiplier, and cost per rentable square foot, are applied to specific asset types. Most appraisers use two or more and reconcile the results rather than relying on any single figure.

The value of commercial property is the most important factor for investors when making investment decisions. Over the past few decades, investing in commercial real estate has become more popular as private, corporate and public wealth investors seek stable returns.

In this guide, we share our expert knowledge and insights into commercial property valuation methods, break down the complex principles of calculating a commercial property estimate value and look at how powerful software solutions can support the consistency, transparency and standardization across the valuation industry.

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.

• Cost approach

• Sales comparison approach

• Capitalization rate approach

• Discounted cash flow approach

• Other methods to consider

• Which valuation method should you use

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.

How the main valuation methods compare

Cost approach

The cost approach values a property as the cost of the land plus the cost of rebuilding the structure today, less accumulated depreciation. It answers whether buying an existing asset is cheaper than building an equivalent one from scratch. It is most useful for new construction and special-purpose buildings, and least useful for stabilized income-producing assets, because it ignores cash flow entirely.

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, which is crucial for an accurate commercial property valuation.

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

The sales comparison approach values a property against recent sales of similar assets in the same market, adjusted for differences in condition, location, size, and tenancy. It is also the source of the market inputs every other method depends on, including cap rates and replacement costs. It requires a reasonable volume of genuinely comparable transactions, which limits its use in thin markets.

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 (discussed below), 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

• Location

• 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, making it a less comprehensive method for commercial property valuation.

Read about commercial property comparative analysis

Capitalization rate approach (also known as income capitalization)

The capitalization rate approach divides a property’s forward net operating income by a market cap rate to produce a value. It is the most widely used method in lending and in the first pass on an acquisition. It assumes a stable, predictable income stream, so its accuracy falls away sharply on vacant, transitional, or capital-intensive assets where a stabilized NOI does not yet exist.

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 commercial 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 commercial property estimate value 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).

A worked example makes the sensitivity clear. A stabilized office asset producing $1,200,000 in forward NOI, in a submarket where comparable properties have traded at a 6.5% cap rate, indicates a value of roughly $18.46 million. Move the cap rate 50 basis points to 7.0% and the same income supports roughly $17.14 million, a difference of about $1.3 million. The cap rate is drawn from comparable sales rather than chosen by the buyer, which is why the comparison work described above carries as much weight in the result as the income itself.

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 as 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 commercial property value and returns an investor achieves during the hold period of a property.

Discounted cash flow approach

The discounted cash flow approach values a property by projecting its cash flows across the intended hold period, including the sale proceeds at exit, and discounting them back to present value. It is the only common method that accounts for the time value of money and for changes in performance over time. Investors prefer it because it matches how a hold-period return is actually earned.

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 takes into consideration time value of money and 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. The discount rate applied to those cash flows is the second lever in the calculation, and small changes to it move the result as much as the cash flow forecast does.

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 commercial real estate professionals value property in the quickest and most accurate way possible. A deeper look at the Discounted Cash Flow (DCF) is available.

Other commercial real estate valuation methods

Three further appraisal methods appear in specific situations. Value per door prices multifamily and condominium assets on a per-unit basis. The gross rent multiplier divides price by gross income and works as a quick screen. Cost per rentable square foot compares a building’s cost against average lease rates per square foot, and is favored for premium assets where rent levels justify the price.

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.

Cost per rent-able square foot, which combines a tenant's 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.

Which valuation method should you use?

The method follows the asset and the data available, not the analyst’s preference. A method that produces an outlier is usually telling you something about the property rather than something about the math, which is why reconciling two or more is standard practice.

• Use the cost approach when the asset is newly built or special-purpose, or when the market is too thin to produce credible comparable sales.

• Use the sales comparison approach when the asset type trades regularly in the submarket. Run it even when it is not your primary method, because it supplies the cap rate and cost inputs the others rely on.

• Use the capitalization rate approach on stabilized income-producing assets, and for the first pass on an acquisition or a lending decision.

• Use discounted cash flow whenever the hold period matters, particularly where lease rollover, capital spend, or lease-up will change performance during ownership.

• Use value per door, gross rent multiplier, or cost per rentable square foot to screen and sanity-check, not to set a final number.

Where the process itself is the constraint rather than the method, our guidance on streamlining the real estate valuation process covers how valuation programs are structured across a portfolio.

Most valuations use more than one method

Choosing the right valuation method is like 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 on the $8.9 trillion global commercial real estate market.

Where a valuation has to be relied on by investors, auditors, or a lender, the method matters less than the independence and consistency behind it. Our commercial real estate valuation advisory team works with fund managers and internal valuation teams on exactly that problem.

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