Understanding Commercial Property Value and How to Calculate It
Understanding commercial property value can help when negotiating investment and business deals. Whether you plan to use the property to generate income or sell for a profit, knowing how to calculate the value of commercial property can help ensure you get a good deal.
Here are the most common ways to appraise a commercial property and how to determine which method is best for your business.
How to determine the fair market value of commercial property
There are multiple methods for calculating commercial real estate values, each with its own advantages and disadvantages. Choosing the best approach for your business depends on personal preference, industry-specific standards, the local real estate market, the property’s condition and your overall real estate development goals.
Here is a deeper look at the most popular methods for commercial building appraisals.
The cost approach, or replacement cost approach, incorporates the current value of the land the building sits on, as well as construction costs if you were to rebuild the property from scratch. You would also need to take the building’s depreciation into account, considering the age of the building, any required maintenance or other indicators of wear and tear.
The cost approach can help determine the value of new property on recently sold land or for properties with unique features. It may be difficult to accurately calculate the depreciation on older buildings or estimate the land value in a fully developed area. The cost approach may not be the most effective approach in those scenarios.
Sales comparison approach
The sales comparison approach, or market value approach, depends on transaction data from recent sales of similar properties in the area. The current sales data would indicate a ballpark figure for the property’s worth as long as details such as the size, age, location, neighborhood demographics and condition of both buildings are similar. You’ll need to take any significant differences into account.
The sales comparison approach is best suited for properties surrounded by similar properties in an area with a high volume of commercial real estate sales.
Three to five comparable properties are ideal to get a reasonable estimate. If there are limited comparable properties nearby or the building has quirky features, it would be difficult to determine an accurate commercial property value using the sales comparison approach.
The income approach, or income capitalization approach, is typically reserved for income-generating properties and gives real estate investors an idea of how much they could earn from the property. Investors usually combine data from comparable properties and any costs associated with generating revenue, such as regular maintenance to keep the building functional.
You could adjust the capitalization rate, or cap rate, to reflect specific property features, like the quality of the exterior or current building tenants, as they compare to similar properties. If you can’t determine an accurate cap rate, you can use comparable properties in the area to estimate one.
Gross rent multiplier approach
Using the gross rent multiplier formula to find commercial property value is similar to following the income approach. This approach relies on the property’s gross rent rather than total income and doesn’t account for any expenses related to maintenance or vacancy losses.
You would need to compare the building’s GRM with the GRM of comparable properties to understand how the property stacks up in the market. If there’s a lack of similar information, this approach may not be as valuable as others. Additionally, the GRM approach is most commonly used in conjunction with other appraisal methods to calculate a more accurate fair market value.
Discounted cash flow approach
One challenge with using the above methods to determine the fair market value of commercial properties is they don’t consider how quickly values and market trends can change. The discounted cash flow (DCF) approach differs by looking at the projected differences between the potential purchase and estimated sale price after the holding period, including factors like inflation, reinvestment potential, risk, lease terms and more.
In other words, the DCF approach can help determine if a commercial property investment could be worth it in the long run.
Your cash flow is based on earnings and dividends, while the number of periods refers to how long you expect the cash flow to last, such as 10 or 15 years. The discount rate is how much the business must make to deem the investment worth the overall costs.
Price per square foot approach
If you need to value an office, industrial or retail business property, one approach is to multiply the usable square footage by the per-square-foot price. While this method can help size up investment opportunities, it’s often used alongside methods like the income or sales approach to gain a deeper evaluation of a property’s worth.
If a commercial building doesn’t have a set price per square foot listed, look at surrounding properties with similar features. You can then adjust the property’s value based on age, condition, location and potential uses.
Which commercial building appraisal method is right for me?
As you compare the above valuation tools, it’s important to keep in mind that the ideal commercial appraisal method depends on your business’s needs and long-term goals. For example, there’s no point in comparing selling prices or cap rates for a rural property with no comparable buildings nearby. In that case, the cost approach might be a better solution.
Make sure to consider the commercial property’s location, condition and income potential. From there, see which method can help pinpoint the overall value. You can also utilize several tools to paint an even more accurate picture of the building’s worth.
Commercial property valuation: Who can help?
To ensure the property is valued accurately, consider hiring a third-party commercial real estate appraiser to evaluate the building professionally. The primary responsibility of an appraiser is to provide unbiased information regarding the value of real estate. An appraiser would judge how much the property is worth without including partial opinions.
While a commercial real estate broker could also calculate commercial property value, their opinion might be influenced by their potential kickback from making a high-price deal. An appraiser generally has no such interest in the transaction.
You could contact commercial real estate appraisal firms in your area to find the value of certain properties. For instance, CBRE Group, a national commercial real estate investment firm, provides valuation and advisory services to clients nationwide. Professional appraisers are often certified depending on their experience or education — you may come across certified general appraisers or Member Appraisal Institute (MAI)-designated appraisers, for example.