Posted on July 24, 2023
The Best Methods for Valuing Commercial Real Estate in 2023
Price does not equal value.
It’s a simple principle every commercial appraiser understands. Price is the amount a buyer is willing to pay for an asset. It can change from moment to moment in response to supply and demand. Value is more enduring because it is a measure of worth.
Consequently, the commercial real estate valuation process attempts to answer questions such as:
- “What needs does this property meet?”
- “What benefits does this property produce?”
- “What is the future usefulness of this asset?”
Both value and price are quantitative. However, value is also qualitative and, therefore, somewhat subjective. It is the outcome of what stakeholders in a specific market perceive, the opinions they form based on those perceptions, and the actions they take based on those opinions.
That said, the most credible opinions are supported by facts and evidence. In this article, we’ll explain the specific approaches or valuation methodologies commercial real estate appraisers use to assure their clients of the quality and dependability of their valuations.
The Origins of Valuation Methodologies
Construction boomed across the United States during the Roaring Twenties. But that decade was also a time of rampant real estate speculation. The Great Depression of the 1930s starkly and painfully revealed the consequences of buying and selling commercial properties in the absence of widely applied valuation standards and best practices.
Ever since, the appraisal profession has collaborated with the federal government to develop, review, document, and consistently apply standard property valuation methodologies. Those efforts arguably reached their pinnacle with the appraisal profession’s adoption of the Uniform Standards of Professional Appraisal Practice (USPAP) in 1989.
Once again, financial turmoil — the savings and loan crisis — exposed a need to render the commercial appraisal process more transparent. That crisis also prompted individual appraisers and appraisal organizations to hold themselves to a higher degree of accountability lest they be held to such standards by an outside party.
USPAP’s Valuation Method Requirements
USPAP does not explicitly allow or disallow the use of any specific valuation method. Instead, USPAP requires that appraisers “correctly employ methods and techniques necessary to produce a credible appraisal.” That direction includes “clear and conspicuous” disclosure of the valuation method and techniques upon which the appraiser’s analyses, opinions, and conclusions rely.
To determine which method and techniques are most appropriate to the assignment at hand, USPAP specifies that the appraiser should follow these six steps.
- Identify the appraisal’s intended users, including but not limited to the client.
- Identify how that audience will use the appraisal.
- Identify the specific purpose or purposes of the appraisal assignment.
- Identify the effective date for the stated opinion of value.
- Identify the relevant subject property characteristics.
- Identify any extraordinary assumptions or hypothetical conditions relevant to the appraisal.
Only after those assignment parameters have been established does the appraiser determine their scope of work. Two key provisions of the scope of work effectively limit appraisers to using officially recognized valuation methods and techniques.
First, the scope of work “includes the type and extent of data researched and the type and extent of analyses applied to arrive at opinions and conclusions.” Secondly, a scope of work is deemed acceptable when it “meets or exceeds what an appraiser’s peers’ actions would be in performing the same or a similar assignment.”
The Three Most Commonly Used Methods for Appraising Commercial Real Estate in 2023
Commercial appraisers often begin their valuation investigations by asking one or more of these three questions.
- How much have similar properties in the market sold for recently?
- What would be the cost of replacing the current structure with new construction?
- How much income does the property generate?
These questions for the basis of the three most commonly used valuation methods. They are:
- The sales comparison approach (also known as market value approach).
- The cost approach (also known as the replacement cost approach).
- The income capitalization approach (also known as the capitalization rate approach).
Appraisal best practices begin — but do not end — with the application of these three methodologies. USPAP goes so far as to state that appraisers must take special measures to explain the “exclusion of the sales comparison approach, cost approach, or income approach” from “each written or oral appraisal or appraisal review report.”
Depending on the subject property, one of these three approaches may be more appropriate than the others. For example, the cost approach may be more applicable to a Class A office tower built within the last five years, while the sales comparison or income capitalization approach may be more applicable to an apartment complex located near a college campus.
Whatever the case, the appraiser may use any combination of all three approaches to estimate the property’s market value. The final value will be based on the weight of evidence from each approach.
The Sales Comparison Approach
The sales comparison approach is the most common method for valuing commercial property. This method involves comparing the subject property to similar, recently sold properties in the same market.
What makes commercial properties similar? Appraisers examine property size, condition, location, and income potential data to determine comparability. Those data points include, but are not limited to:
- Gross building area.
- Price per square foot.
- Access to infrastructure (transportation, utilities, etc.).
- Vacancy rate.
- Time of sale
- Operating expenses
- Highest and best use
- Ownership interest (e.g., leased fee interest versus simple fee interest).
One of the challenges of using the sales comparison approach is that no two properties are exactly alike. A property may not even be meaningfully comparable to itself at a different point in its history due to the evolving nature of local and national market conditions.
The sales comparison approach thus places a high premium on up-to-date data. It also often involves making many adjustments to account for the differences between properties and the terms of the transactions that generated the sales data being analyzed.
However, adjustments can only accomplish so much. The sales comparison approach ultimately relies upon the existence of comparable properties and the availability of comparable data.
The good news is that the data, when available, is based on actual market transactions, making it highly reliable. Yet a certain amount of subjectivity is still built into this approach. The appraiser must exercise individual judgment in deeming which properties are comparable enough to inform their opinion of value.
The Cost Approach
Unlike the sales comparison approach, the cost approach is not dependent upon an active market. The cost approach estimates the value of the subject property by calculating the cost of building an equivalent structure.
The logic underpinning the cost approach is the principle of substitution. This principle states that a rational actor will not pay any more for an existing asset than they would for what it might cost to produce a new asset offering the same type and degree of utility.
The hypothetical rebuild at the foundation of the cost approach is “from the ground up.” It assumes the land the building occupies is vacant. For that reason, all valuations produced using the cost approach include the value of the land itself in addition to direct costs — materials, labor — and indirect expenses, such as taxes, utilities, and management, maintenance, and insurance fees (TUMMI).
Appraisers define direct construction costs using one of two rubrics: replacement or reproduction.
Replacement cost is the cost to build a new building that has the same utility as the existing building. It assumes the replacement structure would be built using current construction materials and methods, and that it would comply with current design principles, standards, and building codes.
Reproduction cost is the cost to build an exact replica of the existing building, using the same construction materials and methods as the original building. It also assumes the reproduced structure would comply with period-accurate design principles, standards, and building codes.
The difference between replacement cost and reproduction cost for most newer buildings is negligible, and most appraisers use the former rather than the latter. The same is not true for historic buildings. In those cases, reproduction cost is a more accurate indicator of value.
The cost approach also assumes that new construction entails certain property improvements. These improvements lose their value or depreciate over time due to physical deterioration as well as the eventual obsolescence of certain features and amenities.
For example, the COVID-19 pandemic caused many landlords to upgrade their buildings’ HVAC and air filtration systems. Consequently, office buildings featuring outmoded HVAC equipment and offering lower indoor air quality (IAQ) are now less attractive to potential tenants and buyers. Appraisers using the cost approach must calculate the difference between the original installation costs and the value those IAQ solutions currently contribute to the property.
In summary, the cost approach can be represented using a simple formula.
Commercial Property Value = Land Value + (Cost of New Construction – Accumulated Depreciation)
However, each term in this equation must be calculated using one of several valuation techniques. As simple as it may appear to be, the cost approach can be complex and labor-intensive. But it may be the best approach to take when comparable data is in very short supply.
For that reason, the cost approach is most often used when appraising special purpose properties, such as schools, churches, and sports facilities.
The Income Capitalization Approach
Neither the sales comparison nor the cost approach is designed to account for the subject property’s income potential. Income potential is hugely impactful for commercial property types whose value derives (in part) from collections of regular rent payments. Multifamily, office, retail, industrial, and hospitality all fall within this category. Enter the income capitalization approach.
The income capitalization approach assumes that the value of a property is equal to the present value of its future income stream.
Using this valuation method, the commercial appraiser first estimates the property’s net operating income (NOI). NOI represents the property’s total income minus its operating expenses. Operating expenses include property taxes and insurance, but they exclude building maintenance, which is treated as a capital expenditure.
The appraiser then divides the NOI by a capitalization rate (cap rate), which is a measure of the expected return on investment for similar properties. The cap rate is typically expressed as a percentage.
For example, if a property has an NOI of $320,000 and a cap rate of 7%, then the value of the property would be $4,571,428.
The income capitalization approach is a popular method of valuing commercial real estate because it is based on the principle of supply and demand. The higher the NOI of a property, the more valuable it will be. Conversely, the higher the cap rate, the less valuable the property will be. Moreover, many potential investors base their acquisition strategies on the cap rate, meaning it is already a factor in how property values are being utilized.
Nevertheless, the income capitalization approach is not without its limitations. First, it assumes that the property’s future income stream will remain stable relative to its current income stream. This is not always the case, as income streams can fluctuate due to a variety of factors, such as changes in the market or the broader economy.
Another limitation of the income capitalization approach is that it too often relies on comparable data. The cap rate for a particular property is usually keyed to the cap rates of similar, recently sold properties. If comparable properties do not exist or sales data about them is not widely available, appraisers may find it difficult to estimate the cap rate.
Additional Valuation Methods and Techniques You May Encounter in an Appraisal Report
In addition to these three main approaches, appraisers may use several other valuation methods and techniques. Many of these are especially well-suited to special circumstances. They include:
- Discounted cash flow.
- Gross rent multiplier (GRM).
- Value per door.
- Cost per rentable square foot.
- The Capital Asset Pricing Model (CAPM).
The discounted cash flow approach is similar to the income capitalization approach, but it takes into account the time value of money — inflation — and its impact on the property’s future financial performance. It also makes provision for known future changes in revenue, such as an expiring lease that will not be renewed.
The gross rent multiplier (GRM) approach examines the relationship between the property’s value and its annual income, represented by the combined total of all contractually stipulated rent payments. Appraisers calculate GRM by dividing the property’s value by this gross rent. This technique is particularly useful when attempting to determine whether a property’s asking price is high or low relative to its income potential (as measured in rent collections).
Value per door is a method for valuing property based on the number of rental units in the property. Value per door is calculated by dividing the property’s value by the number of rental units. This technique is most often applied to multifamily properties.
The value of a commercial building can also be estimated by calculating the cost per rentable square foot. The term “rentable square foot” refers to the total area of a building that can be rented to tenants, including both individual units and common areas. The average lease cost per square foot is the amount that tenants typically pay in rent for a square foot of space in a particular area. The cost per rentable square foot is well-suited for estimating the value of highly desirable, amenity-rich Class A assets, as it reflects the rent landlords can charge to generate their desired return on investment.
Appraisers working on large portfolios of commercial real estate assets are increasingly leveraging the Capital Asset Pricing Model (CAPM) to generate insights. This financial model assumes that that the expected return on investment (ROI) is equal to the risk-free rate of return plus a risk premium. The risk premium is a measure of the additional return that an investor expects to receive for taking on additional risk.
Commercial appraisers can use the CAPM to estimate the subject property’s cap rate. The cap rate, in turn, reflects both the riskiness of the investment and the expected ROI.
To use the CAPM to estimate the cap rate, the appraiser would need to know the following:
- The risk-free rate of return.
- The market risk premium.
- The subject property’s beta (β).
The risk-free rate of return is the return that an investor can expect to receive on a risk-free investment, such as a U.S. Treasury bond. The market risk premium is the difference between the expected market return and the risk-free rate of return. The beta of the commercial property is a measure of its volatility relative to the market.
Once the appraiser has obtained these three pieces of information, they can use the following formula to estimate the cap rate.
Cap Rate = Risk-Free Rate of Return + Market Risk Premium * Beta
Use of the CAPM to estimate the value of commercial real estate comes with several caveats. Although the CAPM can be applied to properties and entire property types, it is most applicable to a different asset class altogether: stocks. The CAPM also relies on a linear interpretation of risk versus return which is not always applicable to the commercial real estate market. Finally, appraisers typically need to input a significant amount of historical data to yield robust and truly meaningful CAPM results. In some cases, that data may need to span a full economic cycle or go back decades.
Ultimately, the CAPM can be a valuable tool for commercial appraisers, but it should be used in conjunction with other valuation methods to arrive at a more accurate estimate of property value.
Although the valuation methods discussed in this article are the most commonly used by commercial appraisers and offer a good starting point for understanding how commercial property values are determined, there is no one-size-fits-all solution to estimating the value of any given commercial real estate asset. The best method for valuing a particular property will always depend on its specific circumstances.
At LPA, we leverage leading technology, including our own proprietary software, to collect the largest possible pool of market data and analyze it using the full range of USPAP-compliant valuation approaches, techniques, and tools. We also prioritize the usability of every property valuation we produce. We combine commercial real estate valuation best practices with a strong design sensibility to generate business intelligence our clients can access immediately, act on swiftly, and leverage successfully.
Contact us today to learn how you can navigate the complexities of the commercial real estate market with the help of our commitment to unfailing accuracy, best-in-class customer service, and always on-time delivery.