Brad Bonkowski and Andie Wilson: How do we value commerical property?

When determining the value of a residential property, real estate agents and consumers alike have been trained to look at comparable sales values… What have similar properties recently sold for nearby the subject property? In evaluating a commercial property though, the comparable sales value is just one of three important methods used when determining a property’s value.

A commercial property is defined as a property which is zoned and utilized for an industrial, office, or retail use. A residential property with more than four units, like an apartment complex, is also considered commercial. In order to properly analyze the value of a commercial property, the three methods of valuation we use are: (1) comparable sales method; (2) income approach; and (3) replacement cost. The expectation is the methods intersect at approximately the same value. When that occurs, we know we have arrived at the true current value of the property. Recently though, because of the state of the real estate market, we now typically look for two of the three methods to intersect at a common value, with the replacement cost approach typically being the outlier. We’ll show you why.

The comparable sales method is pretty well understood. In addition to considering sales of similar properties, we also look for similar property classes. We wouldn’t want to compare a “Class A” office building sale to a sale of an older, dilapidated office property — that’s comparing apples to oranges. Similar to residential valuations, we look for similar age, size, and location when looking for recent property sales. Additionally, we do consider “the competition”, meaning what other similar types of available properties are currently on the market, and how are they priced? We need to consider supply and demand for available similar product if we’re trying to establish today’s true value. Attention must be paid to what else a buyer has to consider in the marketplace.

The second valuation method is the income approach. This approach only considers the cash flow, or potential cash flow, that a property should produce. For this approach, we look at the operating income and expenses for a subject property, ignoring the physical attributes like location and property class. Here’s a simplified example: Take a 10,000 SF (square foot) office building and assume it leases for $1.00/SF/NNN. The “NNN” means the tenant pays all of the expenses related to the property, so the true net monthly income is $10,000, and the annual net income would be $120,000. If properties are selling today at a 7 percent return (meaning that is the rate of return an investor is requiring), that would peg the value, based only on the income, at $1,714,285. ($120,000 annual income divided by 7 percent = $1,714,285).

The third method used to evaluate property is the replacement value, which estimates the cost to replace or rebuild a property, as that may be an option for a company looking at buying an existing building.

This approach considers the cost of acquiring the land to build (a similar location), the costs of site work, installing all utilities, and the costs of construction of the improvements (the structure). Again, using the same sample 10,000 SF office building, we might use a simplified breakdown like this:

Land Value: ($10.00/SF for 1 acre): $435,600

Site work (grading/paving): $100,000

Utility work: $100,000

Construction (10,000 SF X $100): $1,000,000

Total Replacement Cost: $1,635,600

We find in the current commercial property market that replacement cost can’t generally be relied upon to determine property value as existing properties can be purchased for considerably less than the cost to acquire land and construct a new building. Translation: the costs of construction are high, and headed higher. This is why we still aren’t seeing much new construction locally, even though the market overall is getting stronger. Unless a specific property type is required, like fast food, a gas station, or a medical office building, it often makes more sense to buy an existing, older building and retrofit it, rather than build from the ground up. It’s typical in today’s market the cost approach may come in up to 40 percent higher than the other two valuations. This is a phenomenon of two things: the slowly correcting market caused by the recession, and the high cost of construction materials.

We typically summarize by analyzing and/ or averaging the three approaches. If two of the approaches have values within 5-10 percent of each other, we most likely end up disregarding the third value if it’s significantly different. You can see in our sample the two values came close, so if the comparable sales support a similar value, we have likely accurately determined the current property value.

If a property value needs to be established for estate purposes, often the wisest approach is to hire an appraiser. Commercial appraisals can cost anywhere from $3,000 to $5,000, many times the price of a residential appraisal. However, appraisers typically look back in time in their analysis, while commercial real estate brokers like ourselves consider the current and future trends of the market to determine the current value of a property. This is because an appraisal is typically used to protect a lender providing funding for a purchase or a refinance, while commercial brokers are looking for the value both a buyer and a seller most likely settle on.

Brad Bonkowski, CCIM and Andie Wilson, CCIM are owner/brokers of NAI Alliance Carson City, a commercial real estate brokerage. They can be reached at 775-721-2980.