How To Find The Value Of Commercial Property: A Guide For Property Developers

To be a successful developer, you must find the right place for properties you buy and charge the right price for the ones you sell.

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You may (or may not) have been a fan of math in school, but your life depends on it as a real estate developer. Overvalue the land and properties you buy or undervalue the ones you sell and your rate of return will fall – and your business with it. 

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Thankfully, you don’t have to be a math guru to know how to find the value of commercial property. 

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Over the years, investors and developers have created popular valuation methods that you can use. Moreover, valuation is not just a science, it is also an art where your own personal experience can shine through. 

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In this article, we will cover the most popular commercial real estate valuation methodologies, emphasizing the art and science of coming to a final number. 

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By learning how to find the value of commercial property through these methods, you will be prepared to gain a competitive advantage over other developers. 

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We’ll cover: 

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1. How to find the value of commercial property: 4 popular approaches
2. Factors affecting the value of commercial property
3. Why valuation is crucial for developers

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1. How to find the value of commercial property: 4 popular approaches

The cost approach

The cost approach is one of the popular methods developers use to estimate the current market value of properties. 

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With this method, the value of a property is its replacement cost plus the value of the land minus depreciation. Let’s spend some time understanding the key terms: 

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• Replacement cost: This can be calculated using the replacement method or the reproduction method. 

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For the replacement method, the replacement cost is the construction cost of a new property like the one being valued using new materials, design, and construction methods. The aim is that the new property has the same utility as the one being valued. 

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On the other hand, the reproduction method considers how much it will cost to construct the same property in today’s market using the same materials, construction methods, and design, among others. 

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• Value of the land: How much is commercial land worth? While there are many possible methods, the sales comparison approach is the most appropriate for developers. In essence, consider how much comparable lands are selling for at the moment.

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• Depreciation: Depreciation measures the fall in the value of an asset over time. It can be due to physical wear and tear (physical depreciation), changes in customers’ tastes and preferences (functional depreciation), and changes in economic conditions (economic depreciation). 

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Why is depreciation important under the cost approach?

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The replacement cost measures how much you will spend to build the property anew in today’s market. However, the property we are valuing is not new. The difference between its value when it was new and its value today is depreciation.

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Thus, to arrive at its true value, we need to deduct depreciation.  

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Source: Wall Street Prep

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The validity of the cost approach depends on how well you can estimate replacement cost and depreciation. And this is where the art aspect of valuation comes in. 

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With the former, you can improve accuracy by engaging the services of a quantity surveyor. 

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However, with depreciation, things are more complicated. It is not enough to know how long the property has existed (to estimate physical depreciation), you must also know how the immediate community and its economy (in addition to the general economy) have changed (for functional and economic depreciation). 

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For these reasons, it might be essential to engage the services of an experienced real estate broker or agent. Since they are familiar with the market, they know how the community and its economy have changed over the years. Thus, they can offer more value in estimating functional and economic depreciation. 

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Let’s take an example to illustrate this method. 

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Suppose the replacement cost of the building is $ 10 million  (using the reproduction method) with the land valued at $2m using the sales comparison approach. Also, suppose an experienced real estate agent estimates total depreciation at $3m. 

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Given this information, the property in view should be valued at $9m ($10m+$2m-$3m). 

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Pros of the cost approach

• Very useful when sales comps data are not available: When a property market is inactive or new, it is hard to find the selling prices of comparable properties. The cost approach is a useful alternative to estimating the value of commercial real estate in this case. 

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Cons of the cost approach

• Subjectivity: Given the different types of depreciation, it is impossible to come up with an objective depreciation amount for valuation. 

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• Complexity: Finding the replacement cost of a property can be very complex and developers may be forced to outsource the process to professional appraisers. 

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• Valuing lands: It might be difficult to find comparable land for valuation. This can be because the area is fully developed or the available lands have been restricted for new developments based on zoning laws.

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The sales comparison or market approach

The sales comparison approach is one of the most popular due to its simplicity. 

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It involves estimating the value of a property by finding out the market value of similar properties. This can be done by looking at the price of recent sales or the listing value of those still in the market.

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Before deciding whether two properties are comparable, you have to consider size, condition, location, amenities, environmental risk, zoning laws, and price per square foot (or price per unit and price per key). If they are similar in those regards, then they are comparable. 

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There are instances, however, where properties are not fully comparable.  For example, they may be similar in all other respects except that one has more environmental risk. 

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In those cases, achieving more accuracy may require that you do a downward or upward revision of the value of the comparable property to reflect the difference. This again reflects the fact that valuation is also an art. 

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Source: Research Gate

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Similarly, if there are many similar properties with varying prices, you can use the average value of those properties for valuation.

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Note that the sales comparison approach can be used to value lands as well as properties. 

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If there are comparable lands, you can follow the same process as if you were valuing a property – using average value if there are many comparable lands and revising upward or downward if they are not fully comparable. 

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For an example of the latter consider the case where the land you want to buy is free for any commercial purpose while the comparable one can only be used for an office property (based on zoning laws). 

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In this case, the land you want to purchase is more valuable and you must revise the value of the comparable land upward. 

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Pros of the sales comparison approach

• Simplicity: If the property market in the community is developed, finding sales data of comparable properties is easy. 

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• Cost-effective: If you know where to look, you might not need the services of an expert. 

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Cons of the sales comparison approach

• Difficulty finding comparable properties or lands: If the property or land is unique and/or the property market is inactive or new, finding sales data of comparable properties may be impossible. 

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• Imperfect comparison: Comparison is hardly perfect. Therefore, there may be a need to revise the purchase price to reflect this imperfection. However, this process can be subjective. 

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If property A has a larger parking space than B, how do we value the difference in size? 

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The income capitalization approach

This approach focuses on the net income that the owner of a property can earn from it. 

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Here, the value of a property is its net operating income divided by the cap rate. 

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Before we proceed, let’s clarify these terms: 

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• Net operating income: This is the rental income received by the property’s owner minus the operating expenses incurred on the property.

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If the property has not been recently rented out, you can use the rental income and operating expenses of comparable properties. 

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• Capitalization rate: This is the rate of return that investors expect to earn on a given investment property. You can derive this value by checking the cap rate of comparable properties that have been recently sold. 

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The cap rate is the property’s net operating income divided by its market value. If a property that earns a net operating income of $400,000 was sold for $12m, then its cap rate is 3.3%. 

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Source: WallStreet Mojo

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As in the sales comparison approach, you should consider the cap rate of various comparable properties and then use the average cap rate for your calculations. 

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You may also need to do a downward or upward revision if you believe there are differences between the property in view and comparable properties that warrant a slightly different cap rate. 

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Once you have the net operating income and capitalization rate, you are ready to calculate the property’s fair market value. 

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Suppose that the property in view earns a net operating income of $600,000 per annum and the average cap rate on comparable properties is 3.8%. In this case, the investment property will be valued at $15.79m. 

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Pros of the income approach

• Simplicity: Compared to the cost approach, the income approach is simpler and easier to calculate. In most active property markets, cap rates are readily available and only NOI needs to be calculated. 

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• Intuitive for developers and investors: Using the income-generating (cash flow-generating) capacity of a property for its valuation makes intuitive sense for investors and developers.  

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Cons of the income approach

• Can depend too much on the comparative value of comparable properties: Cap rates rely on sales comparison data. If the property is not currently rented, then NOI also relies on sales comparison data. 

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However, as we have seen, this approach is not perfect. 

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The gross multiplier approach

This approach is similar to the income approach. But instead of cap rate and NOI, we will use gross rent multiplier (GRM) and gross annual income. 

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• Gross rent multiplier: This is the ratio of the property’s fair market value (or sales price) to its gross annual income. It is essentially the number of years it will take for only the property’s rental income to pay for its value (for it to break even). 

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For example, if a property is valued at $5m and earns $800,000 in rent every year, its GRM is 6.25. It will take 6.25 years for the rent to pay for the property.

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Real estate experts consider a GRM between 4-7 to be healthy.  

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Source: WallStreet Prep

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• Gross income: The gross multiplier approach does not consider operating expenses. Only the annual rental income is relevant. If the property has recently been rented, you can use that value; if not, you will rely on the rental income of comparative properties.  

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To find a property’s fair market value using the GRM approach, you need to multiply the GRM and annual gross income of comparable properties. 

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For example, if the comparable GRM and gross annual income are 6.25 and $1,000,000, then the property’s value is $6.25m. 

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Since we are depending on comparative value, everything we have said regarding the upward and downward revision of comparative values and the use of average or mean values also apply here. 

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Pros of the gross multiplier approach

• Simplicity: It is as simple as the income approach

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• Intuitive: Using the income of a property as a valuation basis is intuitive for investors and developers. Moreover, GRM is a useful metric that shows when a property is expected to break even. 

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Cons of the gross multiplier approach

• Ignore operating expenses: Using only gross annual income ignores operating expenses. NOI is more intuitive. 

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• Relies on the sales comparison approach: As we have seen, this approach has its limitations. 

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2. Factors affecting the value of commercial property

From what we have seen about how to find the value of a commercial property, we can summarize the factors that determine the value of a commercial property: 

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Location

If you are using the cost approach, then location matters because the cost of building a property (whether using the replacement or reproduction approach) depends on the property’s location. 

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Also, the rent that a property will command varies by location which means both the gross rent multiplier and income approach depend on location. 

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Finally, the value of comparative properties will depend on location. 

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When you are making real estate development plans, you should consider the location of the land or property when drawing up your budget. 

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Zoning laws

If zoning laws restrict the usability of land, then you have to revise downward the value of comparable properties (if they don’t have the same restrictions) when valuing such land or property. 

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Environmental risk

Environmental risk is another reason to revise the value of comparable properties upward or downward. 

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If comparable properties are in an area prone to flooding, for example, then the value of the property in view must be revised upwards when using the sales comparison approach. 

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Supply and demand

The same property will sell at a different price under different markets and economic conditions. 

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This fact is important when using the cost approach since depreciation has functional and economic components. Market conditions can also affect rental income as well as the prices of comparable properties. 

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Amenities 

Even within the same community or city, commercial properties can command different values based on the absence or presence of important amenities. An office space 5 minutes' drive away from a major road network may not be valued in the same way as one that is 40 minutes away, ceteris paribus. 

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Such differences will be borne out by the rent commanded by both properties (and will be evident in the income or GRM approach). Also, you must pay attention to such differences in a sales comparison approach.  

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Utility

A property that can be easily converted from one property type (say office buildings) to many others (say retail store or warehouse) will command more value, all other factors held constant, than one that cannot be converted or can only be converted to only one alternative use. 

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This difference will be reflected in the income potential and must also be factored in when using a sales comparison approach. 

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3. Why valuation is crucial for developers

We have learned how to find the value of a commercial property. But why is such knowledge important?

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“Price is what you pay, value is what you get,” said Warren Buffett. These words, said in the context of stock investing, apply aptly to real estate investment. 

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Accurate property valuation is how you ensure that there is an alignment between the price you are paying and the value you are getting. This is crucial for the following reasons:

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Avoid overpaying for properties

Overpaying for properties you want to develop can push you into a ditch where you have to sacrifice some returns, attempt to sell the developed property for a premium, or, in extreme cases, sell for a loss. 

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An accurate valuation of properties will ensure you are paying a fair price. 

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Avoid undervaluing your properties 

On the other hand, undervaluing developed properties may affect your bottom line. Lowering the sales price to gain market share or sell quickly is different from selling for $20m because you don’t know the property is worth $25m. 

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Maximize ROI

With proper valuation, you don’t have to overpay for properties or sell them at a discount. In essence, you can maximize your ROI, leaving no money on the table.  

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In a competitive real estate market, accurate valuation can help you gain a competitive advantage through higher ROI.

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Securing funding

You need to conduct an accurate valuation if you have to secure funding to purchase and develop (or redevelop) a property.

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What should you then do when your valuation of a property you want to purchase is less than what the seller is quoting?

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Well, you have to negotiate with the seller.  

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However, in today’s market, commercial real estate investors and developers have to pay earnest money deposits before they can inspect and negotiate the price of a property. Sellers use it to judge the seriousness of potential buyers. 

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Therefore, you must work on securing a consistent source for earnest money deposit financing even as you keep looking for the best deals to pursue. 

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With Duckfund, you can secure EMD for as many commercial real estate properties as you desire. You can complete the application in 2 minutes (no credit report required) and get access to the needed funds within 48 hours. 

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Duckfund also provides special terms for real estate developers. In the first phase (initial title due diligence), you will pay the same financing rates (and setup fees) as investors but in the second phase (feasibility due diligence), you will pay a discounted rate and zero setup fee. 

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[Are you ready to secure more properties for development and redevelopment? Don’t let earnest money deposit requirements stop you. Apply to Duckfund today to get earnest money financing so you can explore more investment opportunities and close more deals.]

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Takeaways

• Proper valuation can help developers maximize ROI and gain competitive advantage
• The cost approach to valuation focuses on the replacement cost of the property, the value of the land, and how the property has depreciated over time. 
• Both the income and gross rent multiplier approach value a property based on the rental income it (or comparable properties) can command. 
• The sales comparison valuation approach measures the value of a property based on the price of comparable sales.
• Location, zoning laws, environmental risk, demand and supply, amenities, and utility are some of the factors that affect the value of commercial properties.