Knowing how to value commercial real estate will help you determine if a property is a good investment.
When searching for commercial real estate to invest in, it’s usually pretty simple to find out how much a property costs. You will likely be able to see the listing price online, call the listing agent, or contact the property owner. However, the listing price doesn’t always accurately reflect what the property is really worth.
For example, a brand-new, state-of-the-art building may be listed at a seemingly fair price, but what if that building is in an undesirable area without any prospective renters? In this case, the property would be practically worthless to a commercial real estate investor who is looking to capitalize on multiple leases in a single building.
To ensure you don’t get stuck in a situation like this, we’re going to share how to value commercial real estate when searching for your next investment property.
How to Value Commercial Real Estate – Glossary
Before we dive into how to value commercial real estate, specifically, let’s cover some important terminology. Understanding these definitions will have you stay in control of the process.
- Cap Rate: A property’s annual rental income divided by the current value.
- Cost Per Unit: A property’s total cost divided by the number of units.
- Gross Potential Rent: The amount of money you can collect from each tenant if all rents are paid in full and on-time.
- Net Operating Income: How much income you make after subtracting expenses that are required to own and operate the property (excluding taxes and financing).
- Price Per Square Foot: A property’s total cost divided by the building’s square footage.
- Return on Investment: How much income you make after debt service divided by the final cost of the property.
- TUMMI: Taxes, Utilities, Management, Maintenance, Insurance.
- Vacancy and Collection Loss: The amount of rental income you lose due to vacant units or unpaid rents.
How to Value Commercial Real Estate – Methods
There is more than one way to determine value for commercial real estate. The best method will likely depend on your unique situation – your goals, the type of building you’re interested in, the size of your investment, and other investors should all be considered when deciding which method of valuation to use.
That said, you can use more than one method to determine the approximate value of a single property. This may help you gain a more complete view of your potential investment.
Here are 6 commercial real estate valuation methods:
Cost Approach
The cost approach considers how much it would cost to build an identical building on the same amount of land. For example, if a plot of land costs $50,000 and the price of constructing a small office building is $1,000,000, the cost approach will value the property at $1,050,000.
This is a good approach to use if you’re interested in a commercial property that doesn’t have many (or any) comparable properties in the area. This is also good to use if your prospective investment property has unique improvements, additions, or features.
Sales Comparison Approach
The sales comparison approach is very similar to doing market research. This method determines the approximate value of a property by assessing recent data for comparable commercial properties in the area. This tends to be the best way to understand the fair market value of your investment.For example, let’s say that you are interested in buying a 10-unit building of salon suites.
To find the approximate value of this investment, you could find a similar property in the area that has been operating for at least 3-years, see how much it sold for, discover each unit’s rental price, and determine the approximate yearly rental income.
The downside to this method is that it isn’t usable in every area. If this is the first building with multiple salon suites in your city, you won’t be able to find any comparable properties.
Income Capitalization Approach
This method considers the yearly gross potential rental income. To find the number, you would simply determine how much each unit generates in one year, add them all together, and subtract losses from maintenance, inefficiencies, repairs, etc. You can use rental prices from comparable nearby properties to estimate your income.
For example, if you purchase a commercial property for $1.5 million and expect to see a 7% yield, based on market research, you can expect to see $105,000 in rental income each year. However, you may be able to increase that number if you figure out how to decrease the amount you lose to maintenance, inefficiencies, repairs, etc.
You might place certain responsibilities on tenants (water and electricity), upgrade to more efficient appliances, windows, and doors, or conduct monthly inspections to catch maintenance/repair issues before they become extremely expensive.
Value Per Gross Rent Multiplier
This valuation method takes the purchase price of the commercial property and divides it by the yearly gross income. This is a good method to use for properties that are listed at a relatively low price compared to how much income they could generate.
For example, if you purchase a property for $1.5 million and you know that it has been generating $105,000 in yearly gross income, your Gross Rent Multiplier (GRM) would be 7%.
Value Per Unit
This method is typically reserved for multi-unit apartment buildings, and it determines a commercial property’s value with the number of rental units. The value is determined by dividing the property’s listing price by the number of units.
For example, if you purchase a building for $5 million and there are 10 units, the Value Per Unit would be $500,000. This method doesn’t take each unit’s size, features, upgrades, or bedrooms into consideration.
Cost Per Rentable Square Foot
This method adds together the square footage that tenants can occupy and common areas that they can use and benefit from. The idea here is to place value on each square foot that tenants can use, compare it to the average lease price per square foot, and, therefore, estimate the entire building’s value.
For example, say the building you want to purchase has 17,000 rentable square feet and the average rent per square foot is $18, annually. You purchase the building for $2.1 million and expect it to generate a 7% gross rental yield. However, after market research, making a few upgrades, and offering attractive tenant benefits, you know that you could charge $21 per square foot, annually. Therefore, that building could potentially generate over $4 million per year.
Final Thoughts
Commercial real estate investment can be tricky to navigate on your own, especially if you’re just beginning your career in the industry. It’s recommended to work with a partner who has plenty of experience with commercial real estate investment, property valuation, and all the small details that go into a successful investment career.
Speed Commercial Real Estate has serviced the Metro Jackson area for many years. Our real estate investment consulting is renowned for helping local investors make smart decisions, grow their portfolios, and invigorate the economy. When you’re ready to invest in your next commercial property, let our experts at Speed Commercial Real Estate be your guides. Contact us today to set up an initial consultation.