June 16, 2024

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Commercial Real Estate Valuation Approaches

3 min read

Cost, sales comparison and income are the three main commercial real estate valuation approaches. Find out more about these methods and other helpful tools for the valuation of commercial properties.

1. Cost approach 

The cost approach is a type of commercial property valuation method that involves separating the cost of the building from the land it’s on. The process looks at the value of the land using sales of similar properties, then adds the replacement cost of the building by considering its age, size, condition and other features that may influence value. Investors may use this method when comparable properties are difficult to locate, including when the building has unique improvements, or when the upgraded structures have added substantial value to the land.

But there are limitations to the cost approach. If comparable vacant land is unavailable, for example, the value will be a less accurate estimate. 

2. Sales comparison approach

Also referred to as the market approach, this method uses recent property sales information to estimate the value of unsold assets. Looking at similar recently sold properties in the same area can help investors determine a fair market value for their building. For example, a six-unit apartment complex might be compared to a similar recently sold structure a few blocks away. Appraisers adjust the valuation to account for differences in age, size and condition between comparable properties. 

The sales comparison method is most effective when there are many comparable properties available for analysis. However, for properties with unique features that are difficult to find in the market, the sales comparison approach may not be the best commercial real estate valuation method.

3. Income approach

Sometimes referred to as income capitalization, the income approach estimates the value of a property based on the income it generates. The formula for the income approach is the net operating income (NOI) divided by the capitalization rate (cap rate). The income approach may be best suited to office, retail and multifamily properties. But it can be particularly involved, as investors should also consider the amount of income generated, how efficiently the property operates and the building’s condition, among other factors, to determine how much the asset may sell for under current market conditions.

Other commercial real estate valuation methods

In addition to cost, sales comparison and income methods, investors may consider other less frequently used valuation approaches, including:

  • Gross rent multiplier (GRM): This metric provides the ratio of a commercial property’s price to its annual gross rental income. For example, if you purchased a commercial property for $1 million and it generates $140,000 in gross rents each year, your GRM would be roughly 7.14 ($1 million/$140,000). This commercial real estate valuation formula is generally used to identify properties with a low price relative to their market-based potential income. Notably, it doesn’t include vacancy rates or expenses.
  • Value per door: Used primarily for multifamily properties, this commercial real estate valuation method focuses on the number of units in a building to determines its value. For example, a building with 20 apartments priced at $4 million would be valued at $200,000 per door, regardless of each unit’s size.
  • Cost per rentable square foot: Rentable square footage combines the usable square footage with the common areas benefitting renters, such as elevators and stairwells. Investors can use this method to assess the building’s value by figuring the cost per rentable square foot compared to the average lease cost per square foot. For example, if a building has 10,000 rentable square feet and the average cost to rent per square foot is $12 annually, the $1.7 million purchase price will generate 7% gross rental yield.

Commercial property valuation is an art

Regardless of the approach investors use, accurate data is critical to any commercial real estate valuation. But remember, even the best data is still an estimate. Ultimately, commercial property valuation is an art, not a science. There’s a subjective element, and the best commercial real estate investors have honed their gut instincts around finding the most attractive deals and most effective valuation methods for each transaction.

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