Valuing Commercial Real Estate

6 Replies

Hey BP,

I initially thought that to value commercial real estate you just use the income approach and apply a cap rate. I have read about other methods such as the cost approach and the sales approach. I am confused in what way I should value commercial properties. Any experienced investors that can give their thoughts? 

Thanks! 

Some are mismanaged. Some are vacant. Some have under market rents. Some have hundreds of thousands in deferred maintenance. Where is it at today? Where can you take it tomorrow? How much will it take?  You should look at all the variables.

@Kyle  Base on what you say, should an empty building cost $0 ? 

The value is whatever the buyer is willing to pay/the bank willing to finance... technically !!! If someone is paying cash, they can pay whatever they believe it is worth. If the bank writes the loan, they determine which factors they would use to determine the value. The city that assesses the taxes also uses different formula to come up with a value.

When I bought my commercial office building, a bank contracted someone to assess the value of the property. In their report, they used 3 approaches to determine the value. Since the bank wrote the loan, they determined which formula to use to determine what they considered the value they were willing to write the loan for. 

As an investor, the income approach is what I would use to determine the value first. If a building is empty and I believe I can fill it quickly ... I wouldn't offer $0 to the seller !!! 

The question you need to ask yourself on every deal is: How much are you willing to pay?

Kyle,

You use the income approach generally, but don't merely look at the in-place income- look at what it could be- and what it would take to get you there, aka a forward-looking pro forma. In the cases of an empty building, the value is not $0 based on the income approach, e.g. If a downtown DC retail building would require $40 PSF (one time) in tenant improvements to get a credit tenant's 5 year lease at $25PSF/yr, and the market cap rate is 5.0%, then our building would be worth $500PSF, less a small adjustment for those tenant improvements and any deferred maint/necessary CapEx.

The income approach, or running a 5-10 year model and targeting appropriate IRR and Cash on Cash return metrics should be the way you the investor derives their ultimate value, but other parties have different goals, thus the other approaches' importance.

The Sales approach matters, one needn't overpay for a building if the market is lower than their required returns, right? Conversely, it doesn't matter what your target returns are, the deal should be selling more or less near the price of similar comps, and the broker knows it. 

The cost approach matters, because it helps determine your development moat- if it's cheaper to build a better building brand new, why should I buy this existing instead of developing my own? If the cost to build new is $200K a unit, it's easier to get comfortable buying a 1980's vintage multifamily property at $130K a unit, even if its features are not the quality of new construction.

Before making a loan, a bank will consider DSCR, your balance sheet, and all three approaches, and anything else they can find to be worried about- because that is their job.

@Kyle Majors Folks prefer income approach as it is the most commonly accepted practice. Also it can be the most robust depending on the accuracy/certainty of your projections.

But, in reality, the comparable (sales) approach is also used (in conjunction with the income approach). In other words, if similar properties with similar characteristics in similar neighborhoods are going for an X PSF (price per sq. foot) then the property under question is similarly priced. 

Cost approach is never used unless you are talking about development (and even then barely) as it is not applicable to these types of assets. 

I would not bother with any cost approach unless it's new construction. I could build a mall in the desert and it isn't worth anything just because I paid $X to build it. Appraiser's include a cost approach to boost their reports.

A sales approach is a good check and balance against an income value. However, a sales approach is EASILY manipulated in an appraisal to justify a higher or lower value. There are too many variables for it to ever be relied upon alone.

An income approach is almost always the best valuation method, especially if the property has multiple tenants. Cash is what matters most. If the property is not stabilized, there are ways to account for this in a direct cap model. Alternatively, a discounted cash flow pro-forma can capture more complex scenarios.

Originally posted by @Jon Mauro :

I would not bother with any cost approach unless it's new construction. I could build a mall in the desert and it isn't worth anything just because I paid $X to build it. Appraiser's include a cost approach to boost their reports.

 I don't think anyone is implying that. It is a useful tool where land is available and Buyers can evaluate risk+new construction may be less than purchasing at an extremely high income valuation.