Here are the four main ways that commercial real estate is valued. When determining the value of residential real estate, investors have a pretty easy time. You simply log into the MLS or check Zillow for comparable properties in the area and utilize the price per square foot to determine the value of the asset you’re reviewing. Analyzing commercial real estate, on the other hand, isn’t quite as simple. There are four common ways to determine the value of commercial real estate, Sales Comps, Cap Rates, Replacement Costs, and the Gross Rent Multiplier.
Sales Comp Method
Commercial Real Estate may also be valued utilizing sales comps comparable properties are similar assets that you can compare by square footage, location, type of construction, year built size, such as low rise, mid-rise, high rise, acreage and so much more. When using this method, you’ll be comparing prices per square foot and adjusting the value based on various different aspects of each site. In sales comps, the price per square foot multiplied by the square footage gives you the property value.
Example:
$150 per SF x 10,000 SF = $1,500,000 value / sales price
The sales comp method is the most commonly used when an asset is largely or completely vacant, meaning the income or obviously a lack thereof, adds little to no value to the property. In this instance, you’ll review the tax records or CRS data to find those comparable properties that have recently sold nearby.
Cap Rate Method
Your next option is Capitalization Rates, or “Cap Rates”. In our experience, the Cap Rate method is the most popular for determining the value of a commercial real estate investment. Commercial properties are largely valued based on the amount of income that they bring to the owner, so investors are essentially purchasing the stability of the cash flow of that asset. A Cap Rate is the anticipated cash on cash return if the asset was purchased in all cash. So, in a Cap Rate scenario, the annual net revenue divided by total purchase price gives you the Cap Rate.
Example:
$100,000 annual net revenue / $1,000,000 purchase price = 10 Cap
Why do investors use Cap Rates? Well, each investment group will have a different acquisition method. Some investors may prefer all cash, some may prefer heavy debt, and others may only utilize a little bit of debt. In each of these instances, the actual amount of cash flow to the investors will change while the property still throws off the same amount in annual net revenue. So, Cap Rates give investors a good 30,000 foot view of the property’s revenue.
Replacement Cost Method
Some investors will purchase assets based on what it would cost to replace that asset. This method is often used hand in hand with sales comps, because it helps the investor determine if the building is worth buying or if they should simply build a new one. These buildings will often require some sort of renovation aspect which will be included in that calculation. In order to properly use this method, you will need to know the cost of acquiring land and building a new property. The Replacement Cost formula is new construction costs minus acquisition cost plus renovation gives you the delta.
Example:
$250 per SF New Construction
-$150 per SF Acquisition of existing building
+$50 per SF Renovations Cost to existing building
$150 (positive delta)
This delta is intended to show the potential profit for investors in this scenario, if that difference is positive, then you could flip the property for a profit or rent it out at market rates. However, if the delta is negative, then you likely don’t have a deal at all.
Gross Rent Multiplier Method
The Gross Rent Multiplier or GRM is another solid method for determining a property’s value. The GRM is a ratio of the total price of the property divided by the gross revenues received from that property. This number will tell you how many years it would take to pay off the property based on the Gross Rents received. Using the GRM, the total purchase price gets divided by the gross rents, which gives you the gross rent multiplier.
Example:
$500,000 purchase price / $50,000 annual rents = 10 GRM
In this example, it would take 10 years for the property to pay for itself based on the Gross Rent Multiplier. The inverse of this method is used to determine an investor’s value of the property. If you want your property to pay for itself in seven years, you would use a GRM of seven. So as the investor, you would take the gross revenues of the property that you’re looking at and multiply that number by your Gross Rent Multiplier of seven. So using that previous example, an investor would multiply the $10,000 in annual rent times seven for a total investment value of $70,000 this number is a bit more subjective than the others, as different investors will apply different GRM’s when looking at assets, so it’s just not as commonly seen as Cap Rates or Sales Comps.
Now, one thing to keep in mind is the market at the end of the day, the market ultimately determines the value of a commercial property, even if you’re determining value based off of recent Sales Comps, market Cap Rates or other methods, the property is only worth what a buyer is willing to pay for it. That’s why you’ll see some properties sell for more or less than you feel they’re worth. The timing in an acquisition or disposition can be everything!