Valuating Commercial Real Estate Properties

Valuating Commercial Real Estate Properties

Valuation is a key component of making smart commercial real estate investment decisions. The price of property, or even what has been paid for that property in the past, are not necessarily equivalent to the value of the property. It is worth taking the time to do the calculations to estimate value before making a decision to pursue or pass up an investment opportunity.

There are three methods commonly used to estimate property value in real estate. The sales comparison approach is used primarily for residential real estate and undeveloped land. The cost approach is best suited to commercial properties that are infrequently bought and sold, such as schools, hospitals, churches and government buildings. For commercial real estate properties that generate income, the income approach yields the most accurate estimates. The income approach is concerned with potential rental income of the property as it relates to investment made in the property.

Via the income approach, you can calculate property value based on capitalization rate. First, estimate the gross annual rental income the property will generate. Next, estimate potential vacancy rates and resulting lost income, as well as anticipated operating expenses such as maintenance, repairs and property management. Deduct these losses and expenses from the gross annual rental income estimate, which yields the net annual operating income.

From here, divide the net operating income by your desired capitalization rate to yield the property value, or the sales price you may be willing to pay. The capitalization rate is the rate of return on the property that you expect based on the investment you will make. You may run the calculations multiple times with varying capitalization rates to see how the rate will be affected by a range of sales prices for this commercial real estate property. However, while you may have a desired capitalization rate at the time of purchase, the actual rate will fluctuate over the course of your investment due to external factors beyond your control, such as changes in the market as a whole.

Once you have purchased the property, the capitalization rate can be used over time as a metric to determine whether to hold or sell the property. If the capitalization rate drops, it may be an indication that you should sell, even if the market value of the property increases. Likewise, if the capitalization rate rises even if the market value of the property does not, it can be worth holding the property.

Valuating commercial real estate properties requires careful research and thoughtful estimation, as well as patience to run series of calculations. However, the benefit of doing so is that you are far more likely to make a profitable investment.