As a Florida State Certified Real Estate Appraiser for 24 years and a Principle of The South Florida Appraisal House, I'll admit that I have fairly informed opinions about how to appraise commercial property and which appraisal methods are best suited to a given situation.
For those inexperienced in commercial investment ownership, the commercial property appraisal process can be unfamiliar and intimidating. There are so many ways to assess the value of a commercial property and it can be difficult to tell which method is "correct". In the following article, I'll discuss the methods that are out there for evaluating commercial real estate and explain which methods I use and why.
Because I focus exclusively on middle core property types, I use the appraisal methods that most regularly apply to these properties. After all, the sale, of a piece of commercial property can absolutely hinge on the commercial real estate valuation - so getting the appraisal right is vital to a smooth property transition.
This, however, is no simple matter. Whether it’s an apartment building, a warehouse, or a shopping center, commercial property appraisal must take into account more factors and pieces of information than the residential appraisal process. This underscores the need to work with a seasoned real estate broker who can bring their experience and 'gut instinct' to the sales process.
Why is the commercial valuation process so complex? Commercial values are often dependent upon uncontrollable elements like the current market price for which spaces rent. In addition, because of the uniqueness of middle core commercial properties, there tend to be fewer available comparable sales upon which to base a valuation.
Thus, I like to use the metaphors of Lady Justice when thinking about how to appraise commercial property. In the case of the properties I represent, Lady Justice is blind, but she also happens to be like the Hindu God Shiva, who has four arms. When I offer a valuation of a property I try to do so "blindly" - that is objectively and based on just the numbers. At the same time, I try to capture the appropriate value of a property by balancing each of the four valuation methods I use, just like the scales of Lady Justice.
Without further ado, let's dive into the various approaches.
1. Income capitalization approach
This valuation method is based primarily on the amount of income an investor can expect to derive from a particular property. That projected income could be derived in part from a comparison of other similar local properties, as well as from an expected decrease in maintenance costs.
Say a building is purchased for $1 million, and the expected yield is 5%, based on local market research. That $50,000 per year in expected income could be enhanced by tightening inefficiencies or passing along other associated costs to the tenant, like electric or water usage. All expected future income is discounted to reflect the present value.
2. The Gross Rent Multiplier approach
The Gross Rent Multiplier valuation method compares a property’s value potential by taking the price of the property and dividing it by its gross yearly income. So, if you purchased a commercial property for $650,000 and it generates $80,000 in rents each year (gross), your GRM would be about 8.13 or $650,000 / $80,000. This method of commercial real estate valuation is primarily useful in identifying properties that are being offered for a low price as compared to their potential income.
3. Value per door
When it comes to how to appraise commercial property, there is another method - this one is usually used primarily for apartment buildings (not warehouses, office buildings, or the like). This method simply determines the entire building’s worth based on the number of units. A building with 16 apartments priced at $2 million, for example, would be valued at $125,000 “per door”. Note that this "per door" is applied without consideration of the size differences present between the units. That being said, this can be a useful metric when paired with other considerations.
4. Cost per rentable square foot
Rentable square footage combines the usable space tenants can occupy with the common areas tenants benefit from, such as stairwells and elevators. Using this methodology, an assessor would extrapolate the cost per rentable square foot. Then, to get a comparative understanding of the building's value, they'd compare with the average lease cost per square foot in your market.
For example, if a building has 10,000 rentable square feet and the average cost to rent per square foot is $12 per square foot annually, a purchase price of $1.7 million will generate 7% gross rental yield. However, if you know you can charge rent of $14 per square foot annually, a valuation of $1.9 million will yield the same gross return.
5. The "Comp" or Comparable Sales approach
Also known as the “market approach,” this method relies heavily upon recent sales data for comparable properties and is often used in residential valuations. By seeking recently sold properties from the same market area, a buyer would, by inference, ascertain the market value for his or her subject property.
For example, a 5-unit apartment complex might be compared to another that sold in the same neighborhood just a few months earlier. While this valuation method is widely used, it does have an important drawback. Depending on local market conditions, it can be difficult to find recent comparable sales for similar properties. This is especially the case with the middle core properties (duplex, triplex, etc.) that I represent.
I use this method to generally inform my understanding of a property. However, but it's not my go-to method when I'm at the point of bringing a property to market.
6. Cost approach
This valuation method considers the cost to rebuild the structure (or an equivalent building) from scratch, taking into account the current value of the associated land as well as construction material and other costs that would be associated with the replacement of the existing structure. So, in the cost approach, the property's value is equal to the cost of land, plus the total costs of construction, less depreciation.
The cost approach is usually applied when appropriate comparable sales are difficult to find. This can happen when a property has unique or highly specialized improvements, or when upgraded structures have added substantial value to the underlying land. The cost approach yields the most accurate market value for when a property is new than through alternative methods.
I almost never use the cost approach in my work, as it's usually not applicable to the types of Middle Core properties I represent. The cost approach is usually used by insurance teams when considering damages and replacements.
In the end, the best commercial real estate investors have honed their gut instincts around finding the most attractive deals on the market. For experienced investors, bringing in a broker who can carefully weigh the value of a property using multiple approaches ensures a sensible, well-informed approach to the next investment.
If you're considering buying or selling a commercial investment property, be sure to seek out the advice of a seasoned real estate broker. If you're in the South Florida area, I'd be happy to talk with you about your property and answer any questions you may have.