When it comes to assessing commercial real estate value, professionals rely on three established methods: cost approach, market approach and income capitalization approach. Investors looking to capitalize on commercial real estate should be familiar with all three methods.
In order to prepare investors and owners, LCI Realty will outline the process, benefits, drawbacks and requirements behind each approach for appraising commercial real estate value.
1. The Cost Approach
Of all three approaches, the cost approach focuses most on the literal value of the structure you own and the land on which it sits. In the cost approach, the commercial real estate value is appraised by assuming that the price a buyer should pay for a piece of property should be equal to the cost of owning and improving it.
As such, as the market price under the cost approach is equal to the cost of the land plus the additional cost of construction, minus the expense of depreciation. When a commercial property is relatively new, this method offers the most accurate market value of all three approaches.
In order to properly use the cost approach, a property or business owner must have access to a comparable vacant land. The value of this land is pulled for the equation. By the same token, the owner must have access to a building that required similar materials and expenses to construct.
Without these comparable values, the cost approach is nothing more than guesswork.
Assuming you have the correct information available, there are two main types of appraisal options in the cost approach:
- Reproduction. This method assumes a replica of the property has been built and gives specific attention to the duplication of original materials.
- Replacement. This method assumes the new structure has the same function as a comparable building but has newer materials and an updated design.
2. The Market Approach
When you invest in a publicly traded company, you know the exact value of your investment at all times. Unfortunately, more than 99 percent of companies in the United States are privately held, making the total commercial real estate value for properties much harder to determine.
The market approach seeks to solve this problem using one of two methods – the Guideline Transaction Method and the Guideline Public Company Method. Both methods appraise a privately held company based on the pricing observed for comparable companies that were publicly traded.
Guideline Transaction Method. The property is valued based on pricing multiples pulled from the sale of comparable publicly traded companies.
First, you’ll need to find transactions that involve similar properties, basing your decision on whether the operations of the company closely mirror your own. In addition, the chosen transaction must have occurred under a comparable industry and economic conditions.
Then, you can apply the indicated pricing multiples, essentially comparing the sale of other property to the value of yours. For example, if property A was publicly-traded and existed in a similar industry and economic bubble as your company, and that property sold for $300,000, it’s fair to assume your commercial property value is roughly the same.
To use this method properly, experts often subscribe to databases that make it possible to search for comparable transactions. On your own, this approach can be difficult to master. We recommend working closely with an experienced professional for detailed and accurate results.
Guideline Public Company Method. Your commercial property is valued based on trading multiples pulled from publicly traded companies that are similar to your own. This may sound like the Guideline Transaction Method, but the process differs in several ways.
First and foremost, you’ll begin by identifying similar companies, as you normally would. Then you’ll adjust your result for differences in size, risk, economic capacity and industry. Under this valuation method, comparability isn’t required. Rather, you adjust to achieve comparability.
In some ways, this method is more accurate, since you’ve acknowledged the small and large differences between the publicly traded property you’ve chosen and the privately held property you own.
As might be expected, using the market approach can result in pricing fluctuations. Still, many investors find the approach quite accurate, since they are able to examine the pricing decisions of publicly-traded companies in real-time to appraise commercial real estate value.
3. The Income Capitalization Approach
The income capitalization approach relies on two numbers: your capitalization rate and your net operating income. To value your property, find these numbers for a comparable company, then divide one by the other.
The capitalization rate of any property is the annual rate of return that investors can expect from it. You can estimate your capitalization rate by looking at the rates of property nearby. The chosen property should be comparable in terms of industry, size, and accessibility.
You’ll also need access to a comparable net operating income. This number is typically equal to the revenue generated from your property minus the cost of operation. For example, you might earn money from rent, monthly fees or vending machines. You might lose money after paying for repairs, general maintenance, property taxes, and other operational expenses.
In theory, your net operating income should highlight the money you earn that isn’t already spoken for. In terms of the income capitalization approach, you can calculate your personal net operating income or borrow the number from a comparable company.
Once you have both your net operating income and your capitalization rate, divide them. For example, your rental might have a net operating income of $300,000 and a capitalization rate of 10%. That means the value of your property is $3,000,000.
Keep in mind that finding the right capitalization rate can be difficult. Small variations can make a significant difference in your final calculation. Make sure you make adjustments to the rates from comparable properties to reflect demand. For example, a difference in location, condition or parking availability can alter capitalization by several percentage points.
To ensure you calculate the value of your commercial real estate correctly, consider speaking to a professional property manager. Although income capitalization is often the most straightforward approach, it can still be tricky.
Contact Our Experienced Team To Learn More
Do you have questions about the commercial real estate value of your property? We can help you master these approaches at LCI Realty. Our property management team takes great pride in working closely with business owners and investors to appraise the value of property, boost the bottom line and guarantee an organized experience for everyone involved.