There are three main methods of valuing commercial real estate, and each offer advantages. This consists of the income approach, the sales comparison approach and the cost approach. The ideal approach for your commercial property will depend on the property's location and type.
The Income Approach
The income approach, also known as the income capitalization approach, is the most common way to value commercial real estate. The process involves establishing a value based on the property's income, and this is accomplished by using the capitalization rate (cap rate). The cap rate is essential the ratio of income to market value, and such incomes and market values are known by analyzing similar properties in the area. Afterwards, the investor may then estimate the market value of his commercial property by dividing its annual income by the cap rate. So, if a property's annual income is $100,000, and the cap rate is 10 percent, then the property would be valued at $1 million.
The Sales Comparison Approach
The sales approach is likely the simplest method of commercial property valuation. It involves taking a survey of nearby commercial properties. The selling price of these properties is then recorded. The investor's commercial property then takes an average of these selling prices, and adjusts them up or down based on square footage. Further adjustments may be made to take into account building upgrades, such as increased parking.
The Cost Approach
The cost approach is a more complex method of commercial real estate valuation. It first takes an estimate of the property's land value, or the value without the building. Then, the cost of building an exact replica of the building is added to this estimated land value. Then, depreciated value is taken into account, which may be represented as a function of the building's age. The newer the property, the more reliable the estimate.
Choosing the Appropriate Valuation Method
If you are new to commercial real estate investment, it is ideal that you understand each of the three main methods of property valuation. By doing so, you may find that your valuation and the property valuer's estimation differ. Furthermore, each of the three methods have their advantages. The cost approach is advantageous for those whose property is located further away from similar developments, and thus selling prices and cap rates cannot be compared. The income approach is straight forward if you have data for cap rates, but it is not ideal for assessing apartment buildings, as vacancy rates fluctuate. In such a case, the sales comparison approach would be the most ideal.