Commercial Real Estate (CRE) is an attractive option for investors exploring ways to build long-term wealth. The right investment property can provide steady cash flow, tax benefits, and asset appreciation despite changing market conditions.
Before securing a property, investors should evaluate specific metrics to determine whether it's worth the time and money. This guide discusses the three most common CRE Valuation Approaches successful investors use across all types of commercial property.
CRE Property Types
CRE Valuation Approaches
Based upon the principle that the value of the property is significantly related to its physical characteristics, and that no one would pay more for a facility than it would cost to build a similar facility in today’s market on a comparable site. In many cases this approach is not applicable due to the age of the improvements and lack of land sales within the market area.
Sales Comparison Approach
Based of principle of substitution. This principle states that no one would pay more for the subject property than the value of similar property in the market.
Based on the premise that properties similar to the subject are income producing, and that investors purchase these properties based upon their income-producing ability. Market rents for the subject property are estimated, the applicable operating expenses are deducted, and the resulting net income is capitalized into a value estimate.
A Sales Comparison Approach provides a way to determine whether a property's asking price is in line with the final sales price of similar properties in the area. Data points often include prior sales information, property characteristics, and data analysis to ensure the asset meets minimum thresholds. Comparisons can help investors avoid overpaying for a property. Investors should pay special attention to the price per square foot or per unit (for multi-family properties) when using this approach.
NOTE: Sales comparables included in the appraisal will provide a neutral perspective on market valuation. A visual inspection of any property is crucial and may clarify why a particular property’s asking price is higher or lower than expected based on comparisons or appraisal data.
Investment firm, Sterling Organization, purchased the 6,200 SF building located at 456 N. Rodeo Drive in Los Angeles for $55 million. The next day turned around and sold the building to Louis Vuitton for $110 million.
A whopping $17,750 per sqft.
Before an investor applies the Income Approach to property valuation, they should understand a few key terms: Net Operating Income (NOI), Capitalization Rate (Cap Rate), and Overall Rate (OAR).
Net Operating Income is the profitability of an asset calculated by subtracting operating expense from rental income.
Capitalization Rate is the ratio between Net Operating Income produced by an asset and capital cost (original asset cost or current value).
Overall Rate is derived from dividing income by an appropriate capitalization rate.
An Income Approach helps investors evaluate whether the property is being sold at a reasonable Cap Rate. A CRE broker or loan appraiser can provide the data needed to perform this analysis. A slight difference in Cap Rate can significantly impact valuation, as demonstrated in the table below.
There is often a heavy emphasis on the Income Approach for determining the value of an investment property. The Income Capitalization Summation Table determines valuation by first calculating income and expense to conclude the NOI. Valuation changes are based on fluctuations on Cap Rate. CRE brokers typically provide this information, but it is also available in the appraisal report ordered by Logix to finance the property.
Capitalization rate (Cap Rate) is the ratio between net operating income produced by an asset and capital cost (original asset cost or current value). Value change specifically based on Cap rate change. Cap rate is one of the valuation methods to determine property value based on Net Operating Income (NOI).
Appraiser suggests a Cap rate of 4.25% for the subject:
$93,384 ÷ 4.25% = $2,200,000 (Rounded)
Hypothetical Scenario at 3.5% Cap Rate:
$93,384 ÷ 3.5% = $2,670,000 (Rounded)
- Cap rate quantifies what purchasers are willing to pay for the NOI available.
- Increasing cap rate to NOI results in a lower property value.
- Higher cap rates are often caused by weak demand.
$10,000 NOI / 10% Cap Rate = $100,000 Value
$10,000 NOI / 5% Cap Rate = $200,000 Value
Without a proper baseline for cash flow, it's difficult to garner the returns that make a property a worthwhile investment. Lenders and investors typically look for a minimum debt service coverage ratio (DSCR) of 1.20X, which means that there is a surplus of 20 cents in income for every dollar of debt.
As this transaction was for a purchase, the appraiser had adjusted 1.25% of current purchase price/market value as an increase to the real estate taxes expense. Depending on the lease, this may be the tenant or landlord’s obligation. However, for multifamily this responsibility would fall on the landlord and should be considered as an increased expense.
Fee Simple Estate
Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.
Leased Fee Estate
An ownership interest held by a landlord with the right of use and occupancy conveyed by lease to others; the rights of Lessor the (leased fee owner) and leased fee are specified by contract terms contained within the lease.
The interest held by the lessee (the tenant or renter) through a lease conveying the rights of use and occupancy for a stated term under certain conditions.
NNN Referred as Triple Net lease
This requires tenant to pay for all expenses related to the property such as utilities, property taxes, and insurance. The tenant pays directly these expenses or reimburses the landlord as CAM charge (common area maintenance expense).
Modified Gross Rents
These leases are written where the landlord and tenant shares expenses for the property. Usually the tenant pays for utilities and landlord pays for property taxes and insurance.
Landlord is obligated to pay for all expenses related to the property such as utilities, property taxes, and insurance.
- Look for investment properties that fulfill your objective
- Higher income?
- Stability of the property and lease?
- Identify risk and opportunities in the submarket
- Look for value-add opportunities
- Thoroughly review lease agreements to identify apparent risk
- Exit clauses
- Rents adjusted to percentage of store revenue
- Real Estate Correction and things to watch out for:
- Aggressive cap rates (Is it truly worth the investment?)
- Rising interest rates
- Closely follow market trends (Big Box, Creative Office, Consumer Demand)
The material presented within this guide is for general informational purposes only and is not intended to provide specific investment or tax related advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Logix Federal Credit Union is an Equal Housing Lender.