Placing a value on a commercial property purchase is the key to making future profits and avoiding potential losses. Investors need a simple but accurate way of determining both the current price and the future earning potential of the desired commercial property purchase. There are three methods that, if used together, will give a reliable figure to offer as either a selling or a buying price.
Compare the recent sales prices of similar-sized buildings in the same area. This is the Direct Comparison Approach. In the past, comparison sales were the sole domain of appraisers. Today, this information is easy to find thanks to the recent popularity of Internet property comparison websites (see Resources). Information on these websites is gleaned from a number of sources, including county public records and listings of past sales. These figures should be viewed as estimates. Property values can change due to renovations, neighbourhood conditions and the time it takes to update public records.
Use the Cost Approach method to give both the buyer and the seller an idea of a property’s value based on the replacement cost of any land improvements. Such improvements include buildings, landscaping and car parks. Use this method only in conjunction with other methods of evaluation. Buyers and sellers who use only this method will face potential inaccuracies based on the condition of the buildings and surrounding land.
Use the Gross Rent Multiplier. It is a more accurate and useful tool for determining commercial property values. Information needed to perform this calculation includes the annual gross rental income multiplied by the number of years the buyer believes it will take to pay for the purchase. In mathematical terms, the formula is as follows: Value = Gross Rental Income x Gross Rent Multiplier. For example, a property that generates £65,000 in gross rental income each year, multiplied by a holding period of 10 years, would place the value of the property at £0.6 million. Using this method is not especially good for vacant apartments and/or offices because of the length of time it takes to find new renters. Investors should build in at least a 5% vacancy factor in their calculations.
Include the Cap Rate method to determine value. Expressed in percentage, this method is calculated by taking the net operating income and dividing it into the price of the property. Net operating income (NOI) is total income minus vacancies and expenses. As an example, if the NOI of a property is £32,500 a year and comparable cap rates are 5%, the property can be valued at £0.6 million.
These methods are excellent for giving a close determination of commercial property value. Beginner real estate investors will also want to utilise the services of a professional appraiser.
Tips and warnings
- These methods are excellent for giving a close determination of commercial property value. Beginner real estate investors will also want to utilise the services of a professional appraiser.