Difference In Valuation of Commercial vs Residential Real Estate

In residential real estate, an appraiser determines the value of a house by analyzing comparable properties that have recently been sold in that area. Although it is not always possible to find an identical match, the goal is to use houses that are closely located to the subject property, similar in size and layout, and have a similar build date and interior. Once the appraiser chooses these comparable properties he assess the differences each one has compared to the subject property (i.e., number of rooms, pool, etc.) and places a value next to each difference in order to arrive to the value of the subject property. The challenge with a residential real estate appraisal is that it is often subjective depending on the value that the appraiser assigns to each of the differences between the properties and it lags behind the market since the comparables used are typically houses that were sold 1-6 months in the past. Therefore, in a hot market it is difficult for the appraisals to keep up with the rapidly increasing prices.

When you are considering the value of a commercial property the manner of appraising is fundamentally different. This is because the primary purpose of commercial real estate is to generate income. Therefore, it is the income of the property after expenses (known as the net operation income or NOI) that drives the price of the property. More specifically, the value of the property is equal to the NOI divided by the capitalization rate (CAP rate). We will discuss more about CAP rates in a future article, but a simple explanation is that a CAP rate is the percentage of income the property would produce if it was purchased completely with cash and is dependent on the specific market where the property is located. Therefore, if you had a property which had a NOI of $300,000 that was in a market with a 5% capitalization rate the value of the property would be $6,000,000.

What this means is that commercial properties offer the opportunity to drive appreciation by increasing the NOI. This can be done by increasing the income of the property or by decreasing the expenses. This is a great opportunity that does not exist in the residential world since the appraisal is not tied to the income of the property and is one of the many advantages to commercial real estate. A well-established business plan includes upgrades to increase rents and a management structure to decrease expenses to help investors to receive solid returns for the money they have invested in a property.