Commercial Real Estate Valuation 101

When first approaching the process of valuation for commercial real estate, it is important to distinguish between properties purchased for appreciation and those purchased to generate income. While a property can certainly satisfy both, it's best to calculate these values separately.

Appreciation can be thought of as a bet. Most investors will spot an up and coming city or area and purchase undervalued property. Generally, the best bet is when the surrounding area is growing and increases property values. Bets like this are important to consider, but very hard to predict.

Subsequently, most calculations for commercial real estate valuation are based upon the income of the property. The Capitalization Rate - the amount of money a property earns per dollar invested is particularly important. This ratio provides a clear return on investment number, which we can compare directly to other properties. It is much harder to compare absolute property metrics such as price.

So how do you calculate this for your potential commercial investment? The primary method we use to valuate commercial property is the Income Method, which consists of three simple steps:

1 - Find Average Capitalization Rates in your Market

Look at some recently sold properties and calculate their capitalization rates to find an average range for the property type you are looking at. It is important to pick something of the same class (apartment/office building/warehouse, etc.) in the same local market.

The basic equation for capitalization rate is:

Capitalization Rate (a.k.a., cap rate) = Net Operating Income/Sale Price

Net Operating Income = Gross Operating Income - Operating Expense

Example: We are looking at apartment complexes in Washington State. So, we will use three similar commercial real estate properties to calculate an average Capitalization Rate for this class of investment:

Price	Net Income	Capitalization Rate
$795,000	$79,200 - $32,980 = $46,220	$46,220/$795,000 = 0.0581 or 5.81%
$440,000	$65,520 - $28,972 = $36,548	$36,548/$440,000 = 0.0831 or 8.31%
$325,000	$23,100 - $2,966 = $20,134	$20,134/$325,000 = 0.0620 or 6.2%
Average Cap Rate for Apartments in Washington State valued between 0 and 1 Million Dollars		(.581+.831+.620)/3= 0.0677 or 6.77%

Average Cap Rate for Apartments in Washington State Worth between 0 and 1 Million Dollars (.581+.831+.620)/3=0.0677 or 6.77%

Now we have our average market capitalization rate = 6.77%. This is a fairly typical number for apartment complexes in Washington State - capitalization rates tend to vary between 6% and 10% across the board. If you want to give this a try, just visit cimls.com and look at the properties for sale in your area. Be sure to remember that this will give you an average Capitalization Rate for the asking price - not the selling price (typically resulting in a lower average).

2 - Find the Net Income

Net Income (property revenue minus expenses) is often posted on cimls.com. If it is not readily available, you should be able to ask the seller directly for this information. Do not accept pro forma numbers (estimated) or Gross Potential Income (total income "as if" the property was fully occupied). Also, keep in mind that these numbers are estimates - typically designed only for initial ballpark valuations. When you make a final offer, be sure to use the actual income numbers from the operating statements of the last year or two.

Example:

We are looking to valuate an apartment complex in Washington State where the asking price is $550,000. By viewing the financial section of the property information from cimls.com, we find the income is $80,000, and expenses are $30,000.

3 - Calculate Property Value

Now that we have the Net Income and an average capitalization rate, we simply perform the calculation:

Example:

Now we know:
Average Cap Rate for Apartments in Washington = 6.77% (from Step 1)
Property Net Income = $80,000-$30,000 = $50,000 (from Step 2)

We plug the numbers in to this equation:
Net Income/Capitalization Rate = Property Value
$50,000/.0677 = $738,552
*Be sure to convert percentages into decimals. Otherwise, you will be off by a factor of 100!

Based on our calculations, this looks like a steal! Our valuation shows that the property in question is worth almost twice the asking price!

This is not just a fantasy - it happens all of the time in the commercial real estate world. There are a myriad of reasons why this is the case (high risk property/owner needs to liquidate assets, etc). However, it is critical to take the time to understand why the property is undervalued. Just remember - the owner can do these calculations as well!

Other Methods
The Income Method (above) is our preferred calculation, but there are many other ways to valuate a property. It is always a good idea to look at several of these factors to find inconsistencies. Each unexpected result represents a risk or an opportunity. As an investor, it is your choice whether or not to take it - but it is important that when you take on any risks, you do so intentionally! Two other valuable methods for commercial real estate valuation include:

The Comparison Method
Look at the quoted price compared to properties with similar prices and prices per square feet or prices per unit in the same market.

Replacement Cost Method
Use the comparison method to estimate the value of the land. Then, make an estimate of how much it would cost to build the structure - discounted by wear and tear (depending upon how old the building is. This gives you the cost of replacing this building. Especially for essential structures - like the grocery store in a small town - this can uncover some diamonds in the rough. If the property is undervalued by this method - business owners will prefer to buy your property or rent from you rather than building a new building!

While the Income Method is the most concrete method, there really is no hard and fast rule to valuating commercial real estate. Methods and results will vary widely across market and property type. The key for an investor to keep in mind is that any numbers that stick out - any aberrations - represent risk. This risk carries with it potential for failure and success. As always, it is up to you as the investor to determine whether or not the risk is worth taking.
http://www.cimls.com/education/Commercial_Real_Estate_Valuation_101.php