Understanding How to Value Commercial Property the Right Way
If you are planning to buy a commercial property, the first question that will come to your head is, “How much will it cost?” Well, there are various factors that decide the total cost of a commercial property. Starting from place value to the area of the property, you need to consider everything while calculating the total price. Whether you use the property to start your office, rent it out to generate income, or even fix and flip it, you need to know the right amount that you should pay for the place.
How to determine market value of a property
Your research can make the difference between a profitable deal and a non-successful transaction. Before you know how to value commercial property, it is essential to understand that there are a few uncontrollable elements that can affect the total cost. Also, you also need to consider the maintenance cost of the property before buying. Lastly, you need to understand the amount of money that the seller wants and how much you can afford.
Sometimes it is quite complicated to value a commercial property. It is not like a residential property that hardly has several price determining factors. However, there are a few approaches that can help to assess the value of the commercial property.
How to calculate land value of a commercial property
The market value of the land of a commercial property depends on the average market worth of the land. It is independent of the property built on it. For example, if the value of a commercial property is $50,000, its land value may be $15,000. So, the total value of the property will be $65,000. But how will you understand the market value of the land? It depends on a few factors, such as the following:
• Size and condition of the land.
• Proximity of the land to nearby attractions, transportation facilities, and jobs.
• Current demand of the properties in and around the area you want to buy your commercial property.
• Comparable sales value of the properties built around similar lands.
Market values of commercial properties can fluctuate every year depending on the change in demand. So, you need to keep an eye on the rate at which the real estate marketing is growing also.
Different ways to calculate the value of a commercial property
Although it is hard to specifically say the cost of a commercial property, you can still calculate the average price using a few methods. Some of the most common methods that people follow to understand how to value commercial property are as follows:
Income approach valuation
The income approach has a direct relation to the overall rental income of the property’s cap rate. You can calculate the value of a commercial property using the following equation:
Current Value = Net Operating Income or Cap Rate
It is easy to calculate the cap rate of a specific commercial property. Real estate experts usually extrapolate the market sales of similar commercial properties in and around the same neighborhood. You can later adjust the cap rate depending on the different features of the property like attractive façade or high-quality tenants. However, the final cap rate of the property should always be within half the percentage of the average of the local properties.
For example, if the average cap rate of similar commercial properties is 8%, then you should either calculate the value according to 8% or at least 4%. So, if you want to purchase a commercial property that has a cap rate of 8% and an annual NOI value of $700,000, you will have to pay approximately $875,000 if you keep a fixed 8% cap rate. Ideally, you should calculate the value according to the average cap rate instead of the half percentage point. It helps to deal with price fluctuations in the market.
One of the advantages of using the income approach is it helps to understand the recent sale activity according to its comparable properties. If you decide to fix and flip the commercial property in a few months, you will get an idea about the approximate amount of money that you can earn. This is the best method to calculate the closest value of the commercial property.
However, many people point out that they cannot account for collection loss or the amount you lose if the property remains vacant. This will eventually lead to a higher NOI and an increased value. This method also doesn’t consider any elaborate repair expenses that you may need to incur in the future.
Cost appraisal approach
The cost appraisal approach is another popular method to calculate the value of a commercial property. It looks into the land value of the area along with the total cost to construct the property from scratch. That is why you need to understand the different reasons that contribute to the value of the land on which the building stands. For example, if a piece of land costs $50,000 and you are planning to build a six-storey building; the total cost of construction comes to $500,000.
In this example, you will have to pay approximately $550,000. However, you also need to calculate the cost of registration and various legal fees during the construction process. Keeping that cost aside, the basic cost of the property will be $550,000. The cost appraisal approach assumes that you are paying the highest cost that the property may have in that neighborhood. So, if the price of the property according to the income approach valuation comes to $500,000, the final price according to the cost appraisal approach will be significantly more.
There are several other factors that also determine the total price of the commercial property. For example, if you are purchasing a property in a land that produces oil underneath, you will have to consider a value depending on the income you generate by selling the oil or the rental value of properties around that area. There are many zoning laws that affect the cost approach method. Since many people use commercial properties for different purposes, there are certain laws that determine the overall price of that place.
Lenders usually find out how to value commercial property using the cost appraisal approach. The biggest benefit of this method is it offers you the current valuation of your property. In fact, it is the most practical way of calculating the value of commercial properties because it considers most of the real-life conditions. However, it doesn’t calculate the income of the property if you rent it or fix and flip it.
NOI divided by cap rate
NOI divided by cap rate is quite similar to how you calculate a property’s value using the income approach. However, there is a difference in the cap rate and how you calculate the gross rent. This process is also known as the Gross Rent Multiplier or GRM approach. Consider GRM as any value that is greater than 1. On the other hand, the cap rate from the income approach has a percentage that is less than 1. Apart from this basic difference, the GRM also relies a lot on gross rents instead of NOI.
The GRM method doesn’t consider the expenses for repairs or collection loss in the future. You can calculate the value of the commercial property using this formula:
Property Value = Annual Gross Rents (AGR) multiplied by Gross Rent Multiplier
You will have to come up with the GRM of various comparable properties to get an accurate figure of your commercial building. Most people get in touch with appraisers and local commercial real estate agents to know the average GRM to understand how to value commercial property. For example, if you are evaluating a property that has an average rental value of $90,000 every year with a GRM of 8, the present value of the property will be $720,000.
This is probably one of the easiest methods to calculate the value of a commercial property. It is more accurate than the other methods. Moreover, you don’t have to consider a variety of factors to determine the cost of the property. Once you find the average rental value and approximate GRM, you can quickly calculate the amount. Although this is a popular approach and offers an accurate valuation, you still cannot consider some important factors like collection and vacancy loss, expenses on repairs, and things like that.
Experts believe that it is always easy to calculate the approximate value of a commercial property using any of these methods. However, if you want to get a more accurate value, you need to combine these systems. So, ideally, you should calculate the individual values using these methods and then get an average value depending on the price of similar properties in the neighborhood.
Unless you consider the average price of the properties in the locality, it is not possible to determine the cost of a commercial building. This is also true for any other property, including residential apartments.