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Understanding Commercial Property Value

Valuing commercial real estate doesn't have to be complicated. Here's how it works.

[Updated: Feb 04, 2021 ] May 26, 2020 by Liz Brumer
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Commercial property value works differently than residential property value. In residential real estate, comparable property is the guiding valuation model, but that valuation method doesn't transfer to commercial real estate (CRE). Determining what an industrial property or apartment building is worth can be complex, and depending on the type of property, the valuation of the commercial property will put different property factors into consideration.

Whether you're a new real estate investor or an experienced one looking to gain a better understanding of commercial real estate value, this article will be helpful. Below are the four ways commercial property is valued.

1. Cost approach

This method of valuing commercial property is done by looking at the total cost to rebuild the property, including the value of the building itself and the land. This method takes into account the current condition of the property, the cost of construction, and comparable sales of similar properties.

Most commonly used by tax collectors to derive the taxable value of the property to assess the annual tax bills, the cost approach is also frequently used for property insurance, allowing the property owner higher coverage than the property may produce based on its income alone.

2. Income approach (cap rate)

The income approach is one of the more popular valuation models for commercial property appraisals, which uses a property's capitalization rate (cap rate) and net operating income (NOI). This method looks at the property's rental income and operating expenses in order to derive the NOI, then divides the net operating income by the cap rate, which provides the property value.

For example, if a commercial building has an NOI of $460,000 and the market cap rate is 8%, the property value would be $5.75 million. Cap rates will vary based on the property location, property type, age, and condition of the property. In commercial real estate investing, the income capitalization approach is the best valuation tool to help determine the worth of a property as it relates to its cash flow in the current market.

3. Gross rent multiplier

The gross rent multiplier (GRM) model values a property similarly to the income approach but instead of using NOI and cap rate, it uses a property's gross rent. The GRM of a property is usually derived by averaging comparable properties' GRMs (gross rent ÷ sale price = GRM). For example, if a multifamily property produces a gross rent of $225,000 a year and similar properties have an average gross rent multiplier of 9.1, the property value would be $2,047,500.

This model does best at projecting the potential income of a property as it relates to its value, but it does not take into consideration the property expenses or vacancy rate.

4. Sales comparison approach

The last common method to determine commercial property values is the sales comparison approach. This model looks at similar properties in terms of square footage, number of units, CRE sector, condition, and location that have recently sold or are listed for sale. Adjustments are made to accommodate positive or negative differences between properties.

This model is common with appraisers or brokers, and while it provides recent data for the relative market, it does not take into account the property's expenses or current performance in relation to its potential.

Commercial Property Value Models

Cost Approach Income Approach Gross Rent Multiplier Sales Comparison
Value of land + value of building Current value = net operating income ÷ cap rate Value = annual gross rent x gross rent multiplier Average of comparable properties in similar condition, age, area, and type

Knowing the varied methods for valuing commercial property will help you be a more informed real estate investor and be able to better assess the value of a particular investment. Each model has pros and cons, and no valuation model is perfect. It's for this reason that many assessors, appraisers, brokers, investors, and commercial property owners will use a combination of these methods to determine their property's value. In most cases, a licensed professional can help you determine which model is best for your intended use or particular property.

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