Knowing about commercial real estate valuation is an essential skill that real estate investors must have. They need to evaluate the asset’s value before buying it in order to not pay more than its worth. Sellers have to know the value so they can maximize returns from the property. Likewise, banks and lenders are only willing to provide loans if the property is valuable enough to cover the loans and generate enough income to service its debt.
Many factors affect commercial real estate valuation, including the costs of land and property construction, availability of comparable properties within the target area, the current rental rates, and, of course, how much the investors are willing to pay.
Let’s evaluate the most common types of commercial real estate valuation.
4 Most Commonly Used Commercial Real Estate Valuation
1. Sales Comparison
Sales comparison is a valuation method that utilizes information of recently sold comparable properties in the target area. This approach gives a snapshot of the price of comparable property, which can be close to what you can get for the appraised real estate. However, finding a comparable can be challenging, especially within a particular location. It is also not applicable for one-of-a-kind property, which has no comparable available.
2. DCF Analysis
Discounted Cash Flow Analysis is one of the main approaches used by investors and appraisers in commercial real estate valuation. It utilizes the essential metrics for valuation: future economic benefits (free cash flows) and discount rate. Expected free cash flows generated using the asset are discounted to its present value through a discount rate. A commonly used discount rate is WACC (Weighted Average Cost of Capital), which considers both the cost of equity and debt cost. If the present value exceeds the replacement value, the company can proceed with the proposed real estate acquisition. However, DCF Analysis is a more complicated approach than other methods and needs more analysis and know-how in financial metrics and building projections.
3. Capitalized Earnings Valuation
Capitalized earnings valuation considers income as the primary determiner of value. It is calculated by taking the Rental Income, divided by the Gross Capitalization Rate (Cap Rate). Another way of computation is Net Operating Income divided by the Net Cap Rate. However, using the Gross Cap Rate would be easier to compute for investors since more public data is available for rental income. Also, identifying the operating expenses would be difficult to estimate since every real estate investment is different.
4. Replacement Value
Replacement value is one of the alternative commercial estate valuation methods. It is the estimated costs for land and construction (materials, labor, overhead) if you build the property yourself. Though, it does not consider the cost of demolition, debris removal, and material premiums. Replacement value can provide a reference point of the maximum amount you can afford to pay in acquiring an existing property.
Usage of a particular commercial real estate valuation approach would depend on varied factors such as location, data availability, investment purpose, and the kind of property being appraised. It is essential to evaluate what’s the most applicable one for you. And it is helpful to select the combination of two or more valuation approaches to create a smart and reliable investment decision.
