When looking at the ways to estimate the value of commercial property there are three essential methods that can help understand the process.
A. The Direct Comparison Approach
B. The Cost Approach
C. The Income Approach (which includes the DCF method and the Capitalization Method).
The direct comparison approach uses the recent sale details of similar properties (similar in size, location and if possible, tenants) as comparable properties. This method is quite common, and is often used in combination with the Income Approach.
The cost approach, also called the replacement cost approach, is not as common, is done by determining a value for what it would cost to replace the property.
The income approach is the most common, and there are two commonly used income approaches to value a property.
1.The simplest way is the capitalization rate method. Capitalization Rate, more commonly called the “Cap Rate”, is a ratio, usually expressed in a percent, that is calculated by dividing the Net Operating Income into the Price of the Property. The cap rate method of valuing a property is where you determine what is a reasonable cap rate for the subject property (by looking at other property sales), then dividing that rate into the NOI for the property (NOI is The Net Operating Income. It’s equal to income minus vacancy minus operating expenses). Or, you could figure out the asking cap rate of the property by dividing the NOI by the asking price.
For example, if a property has leases in place that will bring in, after expenses (but not including financing) an NOI of $10,000 in the next year and comparable properties sell for cap rates of 6% then you can expect your property to be worth approximately $166,666 ($10,000/.06 = $166,666). Meaning, if the asking price of a property is $169,000, and it’s NOI is estimated at $10,000 for the next year, the asking cap rate is approximately 6%.
Where this gets tricky is when properties are vacant, or where the leases are set to expire in the upcoming year. This is often when you are forced to make some assumptions.
2. The DCF method, or the Discounted Cash Flow method. The DCF method is often used in valuing large properties like downtown office buildings or property portfolios. Multiple year cash flow projections, assumptions about lease rates and property improvements and expense projections are used to calculate what the property is worth today. Basically, you figure out all of the cash that will be paid out and all of the cash that will be brought in on a monthly basis over a specific period of time (usually the time you plan to hold the building for). Then you determine what the future cash-flows are worth today.
There are computer programs like Argus Software that help in these types of valuations because there are many variables and many calculations involved.
For the small investors using a combination of comparable property sales and income valuation using cap rates, will provide a reliable valuation. The real issue is helping the seller understand that they should sell based on today’s income and today’s comparable properties. Don’t buy properties hoping for appreciation. Buy properties today because the property will put more money in your pocket each month than it takes out, and if the property fits within your investing goals.
