Determining the Value of Real Estate

Determining the value of commercial real estate is much different than determining the price of a house, condo, or residential lot. Commercial Realtors typically use up to three different approaches to reach a valuation; the “Cost” approach, the “Market” approach, and the “Income” approach. Each approach has its advantages, but the key to getting an accurate number is to know which methods are appropriate for the property.

Cost Approach. Using the cost approach, value is determined by adding the cost of the land and the replacement cost of the improvements (building). Physical and functional depreciation is then subtracted from the initial number to determine the final value.

One issue with this method may be that land value is hard to estimate because of lack of properties of similar size and zoning with which to compare. This is certainly the case in the Estes Valley where commercial property is relatively scarce and each is somewhat unique. Replacement cost determination can also be tricky, and requires extensive research and knowledge of the fluctuating costs of various building components and tax liabilities.

Market Approach. The market approach looks at recent sales (not listings) of comparable properties. Components to compare include use type, land-to-building ratio, market conditions and terms of sale. Two pieces of knowledge are needed here; knowing the differences in the comparable properties, and the value of those differences. For example, two adjoining retail spaces of the same size may have significantly different values based on parking access, mechanical systems (such as venting for construction of a kitchen), or other amenities not obvious on initial inspection.

Finally, financing or conditions of the sale may make one property more valuable than another. Factors such as cash flow or debt load can impact profitability, and intended use should be considered as well.

Income Approach. Most emphasis is used with the final method, being the Income Approach. A simple formula is used to calculate the value using the income approach; value equals Net Operating Income (NOI), which is the gross rental income less operating expenses, i.e. property taxes, insurance etc., divided by the capitalization rate, which is the estimated return on investment before mortgage payments and income taxes.

On properties that are leased, determining the value is easier since the rental income and operating expense can easily be determined. In the case of vacant properties or properties to be built, the NOI, the first and biggest variable, can be somewhat subjective. The best way to closely estimate is through market knowledge and use of a commercial realtor with experience. Secondly, the capitalization rate is determined by the buyer’s objectives and the current market conditions relative to other investment opportunities.

Although commercial property valuation can be complex, someone with extensive commercial understanding can help guide you through the process of purchasing or selling a property at a fair price that meets the needs of your business and/or financial goals. For sellers of commercial property, knowledge of the accurate value and best use of your property can help you market most effectively to the right potential buyers.