by John Matheson

How To Value Commercial Property

The Most Important Steps To Take When Valuing Any Kind Of Commercial Investment

Whether you are buying or selling commercial property, it is essential to know how to value it. This involves understanding valuation terms, different approaches to commercial property valuation, the differences between commercial and residential valuation, and much more.

There Are Many Potential Approaches to Valuing Commercial Property

There is no single way to accurately valuate commercial property that applies to all situations. Remember that commercial property values are tied to many other elements such as real estate costs and movement, the type of property for rent, how many other properties are available, and the length of a lease for a given property.

As a result, there are many different approaches to valuing commercial property. It is common to use more than one to come up with a value that a renter, lessee, or buyer is willing to pay. Some of those approaches include:

Cost Approach

To determine a cost approach, the evaluator would look at the cost to rebuild the structure if it did not exist, including the cost of the land the property is built upon. This standard method is used when there are no or few comparable commercial properties close by or when a property has a very unique improvement.

Market Approach

This method uses recent sales data for comparable properties. The evaluator would look at buildings or similar properties that have recently sold in the market. This is one of the most common methods of determining a residential property's value, and it does have downsides when used in a commercial capacity. The most common drawback is that there are often not comparable properties to use.

Income Capitalization Approach

Projection income that an investor is likely to get from a specific property after making upgrades is known as the income capitalization approach. This potential income can be figured out by comparing other similar local properties and improvements in capital.

For example, if similar properties are bringing in $50,000 per year, but the costs of a property could be reduced by turning over the cost of utilities to tenants, then the utility savings would be included in the total valuation.

Gross Rent Multiplier (GRM)

This valuation method looks at the property's potential value by dividing the property's price by the gross income. As an example, if a property were purchased for $1 million and generated $140,000 in gross rent yearly, the GRM would be 7.14 ($1 million / $140,000). GRM is most often used to identify properties that are lower in price than their potential income.

Value Per Door

Most often used for apartment buildings, value per door looks at the value of the entire building based on how many units are in. For example, a building with 40 apartments that was listed for $8 million would have a $200,000 per door value, regardless of the specifics of the size of each unit.

Cost Per Rentable Square Foot

When you combine the usable square footage and the common areas available to tenants ( stairways, elevators, etc.), you get the cost per rentable square foot. You can then compare this amount to the average lease cost per square foot to determine if the commercial property offers a good value.

Commercial Valuation vs. Residential Valuation

It is common for a person with experience with residential property to assume that valuing commercial and residential property is similar. This is not the case. There are several significant differences between the two:

  • The methodologies are entirely different.
  • Valuing commercial properties generally involves looking at the income the property will bring versus the property's current value, as would be used with residential properties.
  • Factors that are essential to residential property are not always relevant at all to commercial properties – and vice versa.

In practice, valuing residential and commercial properties is an entirely different process with very different metrics.

Understand Basic Valuation Terms

One of the difficulties of beginning the process of valuing commercial property is understanding the unique language used. It is a good idea to understand these basic valuation terms.

  • Cap Rate. The capitalization rate ( aka cap rate) refers to the rate of return that can be expected from a commercial property. The cap rate is determined by looking at the net income the property should generate and dividing it with the property asset value. Cap rate is expressed in a percentage.
  • GRM. Gross rent multiplier (GRM) is used to determine the value of a commercial property based on its gross rental income. It is calculated by dividing the property's selling price (or value) by the gross rents of the property.
  • Cost Rate. When you divide the cost per unit by the number of rental units, you get the cost rate or value per door. It does not take into consideration the type, size, or physical condition of the units in question.
  • Gross Potential Rent. Gross potential rent assumes that all rent will be paid in full and all units are fully rented to determine the gross potential rent. This is the maximum amount of rent a property can collect in an ideal situation.
  • Effective Gross Rent. When you average out the rent paid by a lessee over the months they are obligated to pay, you have determined the effective gross rent.
  • TUMMI. This acronym is short for expenses related to properties, including taxes, utilities, maintenance, management, and insurance.

While there are many other terms you are likely to encounter, these are the most commonly used terms.

Frequently Asked Questions About Commercial Property Valuations

If you are in need of answers to questions about commercial property valuations, you have come to the right place.

Q: What Can a Commercial Appraisal Report Tell Me?

A: Commercial appraisal reports can cover many factors, including the same types of factors you would see listed on a residential appraisal: comparative analysis, property description, a value estimate, and potential risks.

However, there are additional formats of commercial appraisal reports as determined by the Uniform Standards of Professional Appraisal Practice. These three formats include:

  • Self-Contained reports. Information on the data used to analyze and appraise the property without any reference to files that are not contained within the report.
  • Summary report. A summary of data used to analyze the property value additional data in separate files not included in the summary.
  • Restricted-use report. Only the conclusion of the appraisal with all data in separate files not included in the report.

Q: Who Has Access to a Commercial Appraisal

A: There are precise professional standards in place that determine who can access a commercial appraisal. Unless the client who ordered the appraisal gives their permission to allow others to access the appraisal, only the seller and property tax appeal board will have access to the appraisal.

Q: How Does Depreciation Affect the Value of a Commercial Property?

A: Depreciation is considered if the cost approach method of valuation is used, as described above. In that method, loss caused by physical deterioration or property being obsolete due to functional or external factors is considered.

Two types of depreciation can affect a property – curable and incurable. Curable, as the name suggests, can be remedied cost-effectively. Incurable depreciation can often be remedied too, but it will cost more to remedy the issue than will be recouped in appreciation.

Q: What Common Mistakes Are Used When Valuing Commercial Property?

A: Not using current costs that reflect inflation and market trends, relying on depreciated values taken from financial statements instead of considering replacement costs, and looking at outdated asset records.

Q: What Does the "Highest and Best Use" Refer To?

A: This is defined by looking at the most probable and reasonable use the property will have to support the highest value. The most probable use or the highest use must be legal, physically possible, financially applicable, and produce maximum returns. It is based on more traditional appraisal theories that seek to determine the attitudes of potential buyers and sellers.

Q: Why is Commercial Property Valuation Important?

A: A seller wants to get the best price they can for any real estate transaction, and the buyer does not want to pay more than they have to. Further, leases, rents, and the use of a commercial property can affect its value. There are so many factors involved in valuing a commercial property that it is very easy to under or overestimate.

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