The Price is Right: Which Commercial Property Valuation Method Should You Use?

September 21, 2021

Establishing the right commercial property valuation is a requirement for closing profitable deals, no matter if you’re a buyer, seller, or broker. But here’s the rub: there are several ways to determine the value of a commercial property.

Why? Because “value” means different things to different people. An investor considers a property valuable if it makes them money. An owner-occupant might equate value with the physical cost of replacing a building.

Plus, you won’t always have access to the same inputs to calculate a property's value. A 50-year-old office building has an income and expense history, but it might be difficult to estimate construction costs. A newly built parking structure would offer only build costs and no profit history.

The key to choosing the right property valuation method—the one that expresses the most meaningful definition of value—is to match it to the use case of the building and the available data.

Cost method for new and unique properties

The cost approach relies only on the replacement costs of an asset when valuing commercial property. That makes it useful for unusual properties that don’t have comps and new developments that don’t have income yet.

In the cost method, you tally up the price of the land and the construction costs—materials plus labor—then subtract depreciation (for existing buildings).

Cost method: Land price + cost of construction - depreciation = estimated value of your property

So a new building (no depreciation) that costs $500,000 to construct and sits on a $250,000 piece of property would be valued at $750,000.

Lenders often use the cost valuation method to release funds for new development projects. As more construction is completed on a new project, it has more value. Borrowers then have more collateral against which to borrow more capital to pay for the next phase of construction.

Owners of unique properties that don’t have a rental history will also use the cost valuation method to assess their real estate. A historic mill that’s sat idle for decades, for example, won’t likely have comps in the area or recent income to guide its valuation. So the owner may choose a sales price based on the current cost to build a similar structure on the same piece of land.

The best part of the cost method is that you don’t have to rely on finding comps—which can be much more difficult for commercial property than residential. However, the cost method isn’t as useful for an investor who often cares less about the cost of construction than they do about the financial return on their investment.

Sales comp method for vacant and residential properties

Valuations using the sales comp (aka market value) method are based on the recent sales or listing prices of properties comparable to the one you’re assessing. This approach is useful for common building types—like multifamily downtown condos—where there are plenty of similar comps. It also works well for vacant buildings without income on which to base value.

The theory behind the comp method is that if another building like yours just sold for $500K, then yours could too.

Comp method: Sales or list price of recently sold, similar properties = estimated value of your property

The challenge is finding another property that is fundamentally like yours. To do it, filter a search request on biproxi or use tax records to locate properties that are similar in location, age, property class, and property type. Read here to find better CRE comps.

The comp method has the benefit of automatically taking into account all current market factors because it’s based on a recent, real-life transaction. For the same reason, it’s a valuation that’s easy to defend in negotiations.

However, like the cost method, the comp method doesn’t help an investor understand the value of a property in terms of the income it can generate. And the comp method can be difficult to use for most CRE since there aren’t as many recently sold, similar properties to use.

Price per door or square foot for comps of different sizes

Sometimes, you’ll find usable comps that are like your property in all other ways but size. In those cases, you can estimate the value of your building with the average-per-door or average-per-square-foot method.

The first alternative is to use the average value “per door” of another building and apply it to your property.

Start by dividing the sales price of the comp by the total number of rentable spaces (e.g., offices, condos). Then use that average per-door value and multiply that by the number of rentable spaces in your building.

Average price-per-door method: (total comp price / # of rentable spaces) x # of rentable spaces in your building = estimated value of your property

For example, if a building with 10 units just sold for $1mil, then the per-door value is $100k. And if your building has 12 units, its estimated value is $1.2mil.

This only works well when the rentable spaces are similar in size. So if 25% of the comp is large penthouses and yours is all smaller studio apartments, the per-door method won’t work.

The second alternative is to divide the comp’s sales price by the building’s total square footage to get an average price per square foot. Then multiply that average by the square footage of your property.

Average price-per-square-foot method: (total comp price / square footage) x square footage of your building = estimated value of your property

Say the comp is 25,000 square feet and sold for $1mil; the average price per square foot is $40. If your building is 30,000 square feet, its estimated value is $1.2mil.

Like the comp valuation method, these alternatives give you a defensible price based on up-to-date market conditions. However, they’re only useful if buildings similar to yours have gone up for sale recently.

Income method for investments with profit history

Income is the chosen valuation method for most real estate investors and appraisers. It bases the value of a property on its ability to produce net revenue after operating expenses—which is exactly how most investors analyze commercial real estate.

To use the income approach, divide the property's net operating income (NOI) by the current market capitalization rate.

Income method: Property NOI / market cap rate = estimated value of your property

NOI is the amount of profit the building produces through rental income, parking fees, and any other income streams minus all operational costs like maintenance or professional management fees.

The cap rate of a property is its NOI divided by the building’s value. But for the purposes of this valuation method, you won’t need to calculate cap rates. Instead, you’ll use the current market cap rate as offered by a local broker or as seen on existing property listings.

Let’s say the building you’re valuating has a yearly NOI of $300K and the market cap rate is 6%. Then your property’s estimated value ($300k/6%) is $5mil.

The income valuation method is popular because it treats properties like real estate investments, not just physical structures. Using this method is difficult when NOI isn’t available, though, which makes it less useful for new developments or long-vacant buildings.

Commercial property valuation relies on clean data

No matter which commercial real estate valuation method you use, the calculation will only be as accurate as the information it’s built upon. And unfortunately, there’s a lot of stale CRE data out there.

That was a key motivator behind our decision to build biproxi. The listing data you see here is vetted and continually updated. So you can make confident decisions without sifting through out-of-date or inaccurate information.

Ember Hansen
With over a decade of marketing & business development experience, Ember brings a fresh perspective on CRE to the biproxi leadership team by turning her passion for SaaS into actionable insights for brokers and investors looking leverage technology to create a more successful business.
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