How is Commercial Property Evaluated?

A commercial property evaluation means making an accurate analysis of the current financial value of a real estate property that is meant for generating income through business. It is a useful tool for investors and commercial buyers to assess their investment decisions carefully. A professional property appraisal also helps its owners secure bank loans by showcasing the true value of their property.

There are several different ways or methods of evaluating a commercial property for investment. All of these methods take multiple factors into account before finalizing the valuation process. This article focuses on explaining the major commercial property appraisal methods, along with the common factors that usually affect a property’s value.

Factors Affecting Commercial Property Evaluation

Professional appraisers take into account several factors in commercial property valuation, such as the ones discussed below:

• Place and availability of the market: The nearer the property is to transport and businesses, the more its value. This rule also applies to closeness to consumers and designed infrastructures.
• Building age and condition: Most structures lose value when they become worn and torn, with the exception of those buildings that increase in historical value. The older the building is, the less it has value and the higher its repair costs.
• Market supply and demand: Simple economics also has some effect on property prices. An increase in supply applies downward pressure on prices, whereas an increased demand applies upward pressure on prices and vice versa. (The demand usually comes from tenants)
• Legal considerations: The restrictions and permitted use of a property may have a great influence on its value. For example, the value of it can be reduced by restrictive zoning and other commercial real estate regulations.
• Sustainability and energy efficiency standards: Owners and tenants of property are becoming more appreciative of sustainable building designs and energy efficiency. This can make homes more valuable, which have gone through the LEED certification process, or homes that qualify as ESG.
• Renting potential and lease arrangement: The existing rental rates and the quality of existing tenants may influence the value of a property. It also includes any escalation in rent or vacancy risk.

Commercial Property Appraisal Methods

There are multiple methods that can be used to effectively gauge the current value of a commercial property. Each of them comes with its own considerations and nuances. The most common valuation methods used by professional appraisers are:

• Total cost approach
• Sales comparison approach
• Income capitalization approach
• Discounted cash flow approach
• Some other methods

Below is a detailed discussion on each one of these:

Cost Approach

When it comes to the question of how commercial inspectors assess properties, this is one of the most common ways. This method involves the assessment to reconstruct an existing building. The appraisers try to make an estimate of which will cost more, purchasing the existing building or reconstructing it from the ground up. You also have to take into account the price of the land in total value.

There are two ways you can approach this method:

• Reproduction: Calculating the cost of building an exact replica with the same materials and design, under the same conditions.
• Replacement: It involves the cost calculation of constructing the building with different materials and under different conditions/methods.

This approach is based on good working logic, but its drawback is that it ignores the time and effort invested in the construction of a new building. It also does not pay attention to the cash flow expected from the property over the long run.

Sales Comparison

This is another important method used in the commercial property evaluation process. This approach involves comparing the recently sold properties in the market that are similar to the subject property. Appraisers take into account a lot of factors to base their comparison on, including:

• Price per square foot
• Price per unit (for multifamily units)
• Price per key (hospitality industry)
• Capitalization rate (what cap rate did other structures sell for)
• Physical condition of the building
• Physical location & area
• Income generation and tenant profiles

Even though not exhaustive, the list above captures the most common factors compared between properties for accurate valuation. After comparing these factors, appraisers make adjustments to reflect attributes in favor of or against the subject property. The more similar these properties are in the comparable factors, such as location and cost per foot, the more accurate the final valuation is considered.

Similar to the cost method discussed earlier, this one also does not account for the long-term income potential of the property under consideration.

Income Capitalization

The income approach is another commonly used method of professional commercial property evaluation. Appraisers perform value estimation by dividing the net operating income (NOI) of a property (current or projected) by the capitalization rate (typically, the average market cap rate is used).

NOI in this case actually refers to the gross rental income of the property after subtracting operating expenses. While the cap rate means its annual rate of return based on the income.

The income method is mostly useful when you know that the subject property has a stable countable annual income. In cases where you don’t have this luxury, the discounted cash flow approach has to be used.

Discounted Cash Flow (DCF)

When you are faced with the evaluation task of a commercial property that doesn’t have a stable income yet, DCF brings out more accurate estimates. This method takes into account the expected future incomes and discounts them back to the current value.

One of the greatest appeals for this approach is that it appreciates the time value of money. Many professionals consider it the ideal method for projects with complex cash flows over the long run.

Other Appraisal Methods

Evaluating commercial property for investment has some other methods in practice as well, namely:

• Gross rent multiplier method
• Residual land value method
• Analysing price per square foot
• Per unit or per door valuation

Conclusion

Commercial property evaluation is an important step in its business’s journey, which is normally required in most real estate transactions and bank loan applications. There are several methods a professional inspector/appraiser can follow to make an accurate estimate of its value. Contact Sabreez Home Inspection now to get in touch with professionals who specialize in performing commercial property inspections.

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