Updated: May 4, 2022
Knowing the value of a commercial property is important for several reasons and for several parties, such as lenders, investors, insurers, and sellers of CRE. It’s a common topic and in particular, a question that I'm asked regularly "How do you place value on commercial real estate?"
And I understand why, valuing real estate is difficult. Every property has unique features such as location, lot size, floor plan, and amenities. Although the list below may not cover all techniques, it includes some of the most commonly used valuation methods.
The variations depend on several factors:
1. Quality of the property. Standard designations are Class A, B or C. Does the property need $5mm in Capital Expenditures (CapEx) to get into leasable condition or $0? The answer changes the property value.
2. Property location. This affects the desirability of the property to prospective tenants. If a tenant can attract A+ talent and subsequently increase revenue, the firm is willing to pay a higher dollar per square foot amount. Think Wacker Drive in Chicago or Fifth Avenue in New York.
3. Financials. Revenues, expenses, and required capital necessary. This will ultimately result in the return to an investor’s bank account or Return on Invested Capital (ROIC). If $1mm is paid for an investment property, how quickly will capital be returned?
After these items have been analyzed, a common valuation formula can be used. The Capitalization or Cap Rate indicates what rate of return an investor anticipates receiving. The formula is simple: Net Operating Income (Revenue less Expenses) divided by the value or asking price of the property.
NOI: $1,000,000 / Value: $10,000,000 = 10% Cap Rate.
Inversely, you can determine the price to pay for a building by applying the cap rate to the Net Operating Income.
$1,000,000 / 10% = $10,000,000.
Where the fun begins is at cap rate compression. If a market erupts over a ten-year holding period, the cap rate decreases which means the market and property are more valuable. A gargantuan decrease in cap rates would be five hundred basis points. These drastic changes have happened in areas like Fulton Market Chicago, Nashville, and Austin. If the $10mm property had 3% annual increases to NOI and the market now dictated a 5% cap rate, the value would be as follows.
$1,344,000 / 5% = $26,880,000.
The cap rate is dictated by all aforementioned valuation methods and most importantly what the market is trading at. If a comparable property sells, you can select that cap rate and determine a rough value for your property. This has been dubbed as “slapping a cap rate on it.”
Every dollar added to NOI results in multiple of dollars added to your property value. At a 5% cap, an additional thousand dollars in NOI increases the property value by $20,000! If you save $20,000 on a maintenance project, that money flows directly to your NOI and subsequent property value.
It is a prime principle to always account for every dollar, bid every project, and maximize revenue when managing or owning commercial real estate assets.