Never believe you’re as smart as they say you are when things are good, because you won’t want to believe you’re as dumb as they say when things are bad. It’s one of my favorite quotes and perhaps perfectly encapsulates the importance of proper valuation. Good times can cover up a lot of bad decisions and bad times can often expose them. To a large extent, your own assessment of your intelligence level as described above will be determined by the valuation you apply and the price negotiated up front.
Whether securing a new business location, making an investment, selling your property, or challenging an assessment, the big question will revolve around what it’s worth. Making this determination at a professional level is a rigorous process, theoretically, steeped in economic principles and backed by supportable information about the value of the property. If you are financing the property you intend to purchase the appraisal of market value will likely be ordered by the lender.
It is great to have the satisfaction of mind that your lender will not let you proceed unless the property has a market value in line with the loan amount, but it is really one step too late. It’s necessary to have a solid understanding of the property value before you submit the contract or prepare the letter of intent. If you are working with a reputable and competent broker, they will use the same techniques to help you arrive at an offer price, listing price, or investment value based on your desired return before you have committed yourself.
Three Approaches to Determining Value
The goal of a commercial real estate valuation is to determine fair market value, which is the most probable price a willing and knowledgeable buyer would pay for a property given a reasonable amount of time to complete the transaction. Appraisers and brokers use three primary methods to help identify this value.
Sales Comparison Approach
It’s familiar, popular, and has the potential to produce an inaccurate valuation if not properly conducted or used in isolation. The sales comparison approach does what the name implies. Recent sales (ideally within the last six months, but often within 12-18 months in down periods) of properties are gathered, analyzed, and selected to leave only the ones with the most in common. Real estate is inherently unique and properties are not identical, so adjustments are made to account for material differences between the sold and subject property (for example, one sold property has a new roof and the subject’s roof is thirty years old). Each of the comparable properties will indicate a value for the subject, which must be distilled to one number. With this approach, it is important to note that judgment is just as important as mathematics.
Income (Capitalization) Approach
Commercial real estate is generally valued in relation to its ability to produce income. That’s important. Unlike a house, commercial real estate is purchased as an investment, either passive (think apartments) or direct (think owner occupied business location like a restaurant) with the goal of generating a return. In its simplest form, the income approach allows purchasers to make a determination of value based on the income produced (net operating income) by applying a rate (known as discounted cash flow, capitalization “cap” rate, and sometimes the gross rental multiplier). The rate applied should be commensurate with the risk associated with the property. Three takeaways—1. Commercial real estate is valued based on income produced, 2. The rates applied represent the risk associated with the property, 3. You shouldn’t try to explain discounted cash flow or cap rates in a 900 word article let alone one paragraph.
While the definition of cost approach is fairly straightforward, the application is not. It requires a determination of the reproduction or replacement cost of the structure, subtracts depreciation, and adds back the market value of the land on which the structure is situated to indicate value. It is terrific if you have a PhD in construction, a firm grasp of each building component’s depreciation schedule, and understand obsolescence without looking it up. Keep in mind property cost does not equal market value. It is also the value that is generally highest among the three approaches.
For a proper appraisal, and often broker opinion of value, the values indicated from these three approaches will undergo a process called reconciliation. Simply, the indicated values are reviewed, weighted (not averaged), and a final determination of market value produced.
While not commonly used in the world of small business, many of the large national chains base their real estate decisions on a percentage of anticipated gross sales. This provides a check (or ceiling) for the purchase or lease negotiations. Like any other operating expense (labor, product, etc.), retailers like to keep real estate occupancy costs in a range of 4%-10% of gross sales to increase the likelihood of profitability.
Please do not use assessed value as a replacement for determining market value. While local officials do a fantastic job of conducting assessments (stats will back this up) they are not intended to serve as a determination of value for individual properties. It is a mass appraisal process, which means your property is grouped with other similar properties based on select information and a value is determined by applying a formula. Keep in mind, there is a reason a process is in place to challenge assessed values.
Beware of anchoring. It is a cognitive bias in which we use an initial piece of information (accurate or not) to make subsequent decisions. Once the anchor is established, in this case the asking price or your previous purchase price, it becomes increasingly difficult to adjust away from that anchor.
What Are My Options?
Appraisal—Ideally, an appraisal is the best approach to assist in determining value before making an offer or pricing a building, but often it’s not practical. Appraisals are time consuming and unlike residential appraisals they will often cost several thousand dollars. The price is justifiable; you are paying for expertise. Training and apprenticeship can take years and appraisals are complex and can take several weeks to complete.
Broker Opinion of Value—The BOV utilizes many of the same approaches to determine value (cost approach is generally not considered), but will generally yield a shorter and often less comprehensive report. Like the appraiser, you are buying time and expertise, choose carefully. A BOV can often be turned around in less than a week with supporting material and generally costs less than one thousand dollars.
Gut—Please refer to paragraph one.
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Tim Reamer provides commercial real estate brokerage and consulting services with Cottonwood Commercial and specializes in investment property (multifamily | commercial | NNN), retail/restaurant site selection, and commercial buyer/tenant representation. Learn more at www.timreamer.com.SHARE