Putting a value on most items is relatively easy, but when it comes to valuing commercial real estate the process isn’t quite as straightforward. When you’re buying a commercial property the most important question you want to know the answer to is usually ‘what does it cost?’. However, getting a clear understanding first of what location is actually worth will inform your decision when choosing what property you want to purchase.
Below are two popular approaches to valuing real estate. Whether you’re planning on flipping it, or just running your business out of the location, knowing how much to pay can mean the difference between profit and loss.
Valuing Commercial Real Estate: The Cost Approach
This approach values the property as equal to the land price plus the cost of constructing the building from scratch. For instance, let’s say a piece of land you’re interested in costs $50,000 and the cost to build your new office’s headquarters from scratch is $850,000. Then by using this approach you just sum those two components together and get a value of $900,000.
The Income Approach
Whereas the last approach relied on building from the ground up, this approach relies on the rental income from the property’s cap rate (i.e. a property’s net annual rental income divided by the current value of the property). To get the current value, the net operating income (NOI) is divided by the cap rate. To get the value of the cap rate it’s extrapolated from market sales of comparable properties in the same neighborhood and then adjusted to account for unique features of the property.
While the cost approach has the advantage of providing a current value based on unique conditions, the income approach shines as being able to accommodate recent sale activity of comparable properties. Plus, the income approach can be adjusted for unique factors.
Both approaches have their merits, but regardless of which one you choose you’re already making a better choice to be informed of how much you’re going to be investing when valuing commercial real estate.