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Understanding Commercial Property Value and How to Calculate It
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Understanding commercial property value when buying or selling a building can give you an idea of how much the real estate is worth. Whether you plan to earn income from the property or you hope to sell it for a profit, you’ll need to take the right approach when calculating the value of commercial property to make sure you get the most out of the deal.
How to value a commercial property
There are primarily three methods to calculate commercial property value when evaluating real estate for business
- The cost approach
- The sales comparison approach
- The income approach
The local real estate market and condition of the individual property would determine which approach would be best for a particular building, said Elaine Worzala, director of the Carter Real Estate Center at the College of Charleston School of Business.
“An appraiser would look at all three approaches to come up with an estimate to guide the business owner,” Worzala said. “The more people interested in the market the better.”
The 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 needed maintenance or other indicators of wear and tear.
Here’s a basic formula illustrating the cost approach:
The cost approach can be useful to determine the value of new property on land that was recently sold, or of property that has features that make it unique. It may be difficult to accurately calculate the depreciation on older buildings, or estimate the land value in an area that’s fully developed. In those scenarios, the cost approach may not be best.
Sales comparison approach
The sales comparison approach depends on transaction data from recent sales of similar properties in the area. The recent sales data would show how much the property in question may be 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 major differences into account.
This sample formula shows the sales comparison approach:
The sales comparison approach is best suited for properties surrounded by many similar properties in an area with a high volume of commercial real estate sales.
Three to six comparable properties is ideal to get a good estimate. If there are few comparable properties nearby or the building is not located in a robust market, it would be difficult to determine commercial property value using the sales comparison approach.
Typically reserved for income-generating properties, the income approach gives 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.
The formula you could follow for the income approach is relatively simple:
The income value would be dependent on the property’s capitalization rate, or cap rate, which represents the rate of return on the property. To find the cap rate, you would divide the property’s net annual rental income by the current value of the property. You could adjust the cap rate to reflect specific features of the property, like the quality of the exterior or building tenants, as they compare to the features of similar properties. The income approach relies on several pieces of data that may be difficult to gather in some markets, including discount rates and growth rates, Warzala noted.
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.
Here’s what the gross rent multiplier formula would look like:
To find the property value, you would multiply your annual gross rents by your GRM:
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 comparable information, this approach may not be as useful as others.
Commercial property valuation: Who can help?
To make sure the property is valued accurately, consider hiring a third-party commercial real estate appraiser to do a professional evaluation of the building. 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.
A commercial real estate broker could also calculate commercial property value. But keep in mind a broker typically has personal interest in the property, as they would benefit from the sale. Their connection to the deal may influence their valuation. An appraiser generally has no such interest in the transaction.
You could reach out to commercial real estate appraisal firms in your area to find the value of certain property. For instance, CBRE Group, a national commercial real estate investment firm, provides valuation and advisory services to clients across the country. Professional appraisers are often certified depending on their level of experience or education — you may come across certified general appraisers or Member Appraisal Institute (MAI)-designated appraisers, for example.
Commercial property value FAQs
How do you determine the value of a commercial property?
To find commercial property value, you would need to consider variables such as income from rent, construction and maintenance costs, and the value of similar buildings in the surrounding area. The data that’s available would determine whether you take the cost approach, sales comparison approach or income approach to calculate the value of the property.
What valuation approach is most commonly used for commercial property?
There are three approaches that are commonly used to find commercial property value: the cost approach, the sales comparison approach and the income approach. Individual market conditions would impact which approach is best for a certain commercial property. For example, the cost approach is often the simplest way to find property value but is best suited for brand-new or recently renovated properties.
Who calculates commercial property value for business owners?
Small business owners usually work with professional real estate appraisers to calculate an accurate valuation. A commercial real estate broker would also be able find the value of commercial property.