This article will go over some of the basic philosophies of valuing commercial real estate. There are three methodologies to calculate the value of commercial real estate; the income approach, the sales comp approach, and the cost of approach. The primary valuation used in calculating income on CRE is the income approach.
Many people fall under the improper impression that Commercial Real Estate valuation is driven by the comparable sales method, similar to the residential world. While there are some similarities, they are minor. Commercial Real Estate valuation is derived almost entirely by reviewing the INCOME that the property can and does generate.
Income Approach: CAP Rates & NOI
Like many complex ideas, valuing commercial real estate is based upon a very simple idea. The value of a commercial real estate property as determined by the income approach, which is calculated as the Net Operating Income (NOI) divided by the CAP rate (see my other article explaining CAP rates). Compared to the other two methods, this methodology generally carries 70% of the total valuation in a professional CRE appraisal situation.
A property that has an NOI of $100,000 and a CAP rate of .05 has a value of $2,000,000.
Simple, article over… Not quite.
CAP rates can be extraordinarily challenging to determine, and they can have a tremendous effect on the overall value of a property. CAP rates are determined by comparison the subject property to similar assets, however there are differences between properties based upon:
• Location – a mile can make a difference
• Building age/quality – 1980’s building is different than 1970’s building,
• Time – A sale that occurred 6 months ago is different from one 12 months ago
• Tenant mix – property with multiple tenants will be different than property with one.
Miss the CAP rate by just a little and the property valuation is dramatically changed. In the example above, if the CAP rate is 5.25% instead of 5.00%, that changes our valuation of the property to a new valuation of $1,900,000, $100,000 less than what was originally anticipated. In a purchase transaction with 80% LTV, instead of a borrower coming in with $400,000 at a 5.00% CAP to purchase the property, they will need $500k to complete it at 5.25% CAP.
Similarly, calculating the Net Operating Income must be done precisely, as any small deviation has a SUBSTANTIAL effect on property value. Unfortunately calculation NOI is not as simple as reviewing the income statements of the previous years for the subject property. Appraisers use a combination of actual property expense data and general market averages. Experienced commercial real estate professionals know which expenses to generalize and which are property specific.
A small error in NOI has a large effect in value. In the example above, if that same property has a NOI of $105k instead of $100k, the value (at 5.00% CAP) is $2,100,000. Every minor change is represented