The ability to accurately value real property is an essential skill for any serious commercial or residential real estate investor. A precise valuation can ensure that properties are acquired at a fair price and are sold for no less than full market value. Real estate valuation skills will also come into play when forecasting a return on investment for the subject property, as well as planning for expected costs like maintenance, management fees, and other ongoing expenses associated with real estate investments.
The methodology for valuing residential and commercial properties differ, and investors may or may not need to work with a certified professional like an appraiser to complete their valuation. There are multiple methods property investors can use to determine the valuation of a given property, depending on the situation. Let’s examine some of the most common ways that prospective and current investors can value real estate property.
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Quick Takeaways
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- Property valuations are used by buyers and sellers of real property to reach an agreement on the sale or exchange price of the real property asset.
- Property valuations are necessary for financial, legal, and governmental due diligence.
- Different property types and investment strategies should use different approaches to property valuation.
- The Cost Approach uses land, building, and property value, combined with depreciation to find values for odd, unique, or low volume market properties.
- Commercial property investors should almost always use the Income Approach, unless the subject property is unique or lacks the right comps.
- The Sales Comparison Approach works best for residential properties, but the techniques used in that approach may also be relevant for certain property types, both commercial and residential.
What is Property Valuation?
Property valuation is the method by which buyers and sellers of real estate investment assets determine the market value of a given commercial or residential property. Keep in mind that a property’s value is not the same as its price- the individual circumstances and needs of both buyers and sellers can have a dramatic impact on the final sale price of a given property.
While property valuation is more science than art, there is still a great deal of subjectivity in determining property values- much more so than say, precious metals, which follow an exact spot price that is recognized globally. Property prices are much more fluid, and no parties other than the buyer and seller determine the true market value for real estate assets. Property valuation is art and science, and there are a whole host of professionals, from financial analysts to trained appraisers, to real estate brokers and agents that work tirelessly to determine the most accurate property values possible.
Why is Property Valuation Important?
Understanding the ins and outs of property valuation is an absolute necessity for real estate investors. This determination lays the foundation for projecting ongoing costs like property insurance and taxes. Lenders will also require a valuation before extending financing for acquisitions or refinancing for an existing commercial or residential asset. Finally, property valuations are important for legal matters like distributing property after a divorce, the breakup of a business partnership, leaving property to heirs, etc.
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Different Property Valuation Approaches
There are three commonly used methods for determining the value of real property.
Cost Approach
Land Cost+Property Replacement Costs-Physical/Functional Depreciation=Cost Approach
The cost approach determines the value of a property by starting with the cost of the land, adding in the property replacement/construction costs, and subtracting physical and functional depreciation. This method is typically used for properties that do not have a large sample size of comparable sales. Examples include defunct libraries and government buildings, colleges or universities, medical clinics and hospitals, or any property that is somewhat unique compared to its surroundings.
Investors can find the land cost by researching sales of similar properties in the area. Remember that size is not the only determiner- zoning, the slope and makeup of the property, and proximity to population centers and transportation networks should all be taken into account when choosing a comparable property. One can determine replacement costs by researching the building costs per square foot in comparable properties, multiplied by the total square footage of the subject property. This approach to determining real property value will work on its own, but for commercial acquisitions or sales it is best used as a supplementary valuation, due to the need to take expenses and cash flow into consideration for those properties.
Income Approach
Net Income/Cap Rate=Current Value of Commercial Property
This method, known as the income approach, is the standard valuation strategy in the commercial real estate sector, and in particular multi family residential properties. The income approach consists of calculating the value of a commercial property by determining the net income of the property and dividing it by the capitalization, or cap rate.
The first step in the income approach to property valuation is to collect income and expense statements for the property in question. Alongside those statements, attempt to obtain the same documents from comparable cash-flow generating properties in the vicinity. Collecting this info will help determine the net operating income or NOI of the property. Property condition is also a major determiner of success or failure for commercial real estate investments. Large repairs in the future can dramatically reduce gains from a real estate investment.
Finding the NOI of a commercial property goes something like this:
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- Determine the GPI or Gross Potential Income of the property. The GPI represents the total income generated by a commercial real estate property with full occupancy.
- Next, estimate the effective gross income. You find this by estimating the average vacancy costs of comparable properties- rather than full occupancy. The effective gross income represents a more realistic picture of how well-occupied that commercial building will be.
- After that, it is time to figure out projected property expenses. These fall into two categories of expenses: variable and fixed. Variable costs are those which may change from month to month, such as repairs, management fees, electricity and water payments, etc. Fixed costs are static, and remain the same year after year. Examples include mortgage or loan payments and property taxes.
- Finally, subtract the estimated expenses from the effective gross income to determine the net operating income, aka NOI.
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Choosing a Cap Rate
After you’ve found the NOI, it is time to figure out the capitalization rate. The capitalization, or cap rate denotes the expected rate of return that will be generated from a real estate investment property. One can find the cap rate by examining market sales of similar properties that have been listed and sold in the recent past. The cap rate is among the most important metrics commercial property investors can take advantage of and is an absolute must-know before pulling the trigger on a commercial acquisition.
Divide the NOI by the cap rate, to determine the property’s value.
The formula below outlines this calculation.
Net Operating Income/Cap Rate= Property Value
Every commercial real estate investor should understand and utilize the Income Approach. Remember that much of the value of a commercial property comes from its tenant/client roster, and consequent ability to generate positive cash flow. Using another valuation approach runs the risk of under or overvaluing the underlying economic fundamentals of the commercial property asset.
Sales Comparison Approach
The sales comparison approach utilizes market sale price data to value real estate. Investors and real estate professionals compare the property in question to other, similar properties that have been listed on the market recently and sold. These similar properties are also known as comparable or “comp” properties. They must share some similarities with the subject property, primarily location, but also characteristics like square footage, zoning regulations, year built, total rooms, and other defining features. In certain cases it can be hard to find a property that matches up with the subject property- in these instances, the Cost Approach may work better for accurately estimating the value of the asset.
When finding comp properties to calculate real estate valuation, remember that not every feature will match up with the subject property. These differences need to be quantified and taken into account if the sales comparison is to be accurate. The best way to do this is to research the market value of each feature. For instance, you may have to find out what value a pool adds to a multi family property, or how much an extra kitchen adds to the value of a hospitality property. With that being said, this method is primarily used for residential properties. When determining commercial value, most firms use the Income Approach outlined above.
Summary
Choosing the approach of real estate valuation to take is highly dependent on the specifics of your property acquisition, equity investment, or real property sale. Commercial property investors should almost always choose the Income Approach, or a combination of the sales, income, and cost approaches.
Remember that a commercial property is an income-generating investment vehicle, and the underlying business operations of the property are as important as the physical structure of the building, location, features, and other property-specific characteristics.
While there is no “Kelley Blue Book” of property valuations that lists the values of properties in a handy-dandy guide, using these valuation methods can give investors a solid understanding of how valuable a property is and why. If you’re interested in property investment, contact Trion Properties to find out more about our current portfolio.
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