Why Real Estate is the Foundation of Wealth Creation
March 13, 2024
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You can’t succeed in real estate investment without determining a property’s actual market value. Properly valuing commercial real estate (CRE) is arguably the most critical factor in deciding whether to add a property to your investment portfolio. This skill — evaluating potential acquisitions and current holdings accurately — is essential for any serious CRE investor looking to make smart, profitable decisions.
If you’re new to the industry or an experienced investor with several deals under your belt, understanding the best methods for commercial property valuation is essential for long-term success. So, what are the best practices and methods investors can use to succeed in your investment endeavors?
In the CRE business, the buyer often wants to negotiate the lowest possible price, while the seller wants to secure the highest. So, how do we find a fair middle ground? That’s where accurate valuation comes in.
To determine the value of a commercial property, you need to consider a range of factors. Location, ease of ownership transfer, property condition, and other unique attributes define the property’s worth. Arriving at the right valuation isn’t just about numbers — it requires a balance of experience and market knowledge to reach a figure that makes sense to both buyer and seller. A good valuation process should also give all parties confidence that the outcome is fair, objective, and reasonable.
At its core, a property's value is defined as the present worth of its potential future income. Unlike immediate-use items like food or office supplies, real estate offers long-term benefits that can extend over years or decades. This future-oriented nature of real estate value means that investors must factor in current and anticipated political, economic, and social trends that might affect the property’s performance over time. Understanding value in this way helps investors gauge whether a property will likely bring financial benefits over its lifespan.
To stay informed on these evolving trends and gain insights into the potential future of real estate investment, don’t miss our blog post, “The Future of Real Estate Investment: Trends to Watch,” which highlights key trends shaping the industry.
A property that is highly functional for its intended use gains significant value. Utility in CRE refers to how well a property meets the needs of its future owner or tenant. For instance, a property’s utility could mean its revenue potential for an investor or, in the case of multifamily real estate, how well it serves as a comfortable living space. High-utility properties effectively fulfill their purpose — like an office space that attracts quality tenants or a retail location that draws steady foot traffic — making utility a key factor in the property’s overall value.
When a property type becomes highly desirable, like prime office space in a thriving business district, its value tends to increase. Demand is driven by the strong interest in owning or renting that type of property, along with the financial ability of buyers or tenants to make the purchase. For valuation purposes, demand not only reflects interest in the property but also considers the purchasing power of potential buyers. High demand often increases property values, while lower demand can reduce market worth.
Specific commercial properties are in limited supply, and their scarcity can significantly boost their value. For instance, if industrial warehouses are hard to come by in a high-demand area, their value naturally rises. Scarcity in real estate means that with only so many properties of a particular type or desirable location, those properties become more valuable when demand is strong. This factor is especially important in growing areas, where limited property types can attract premium prices due to the high competition among potential buyers or tenants.
A property that is easier to transfer generally appeals more to prospective buyers, who prefer a smooth transaction process. Transferability refers to how easily property ownership can be transferred from one party to another. Properties with a straightforward ownership structure, such as a single owner and no liens or encumbrances, are easier to transfer and typically more attractive to buyers. Conversely, transferring properties with multiple owners, unpaid liens, or complex legal requirements can be challenging. Transferability impacts a property’s marketability and value directly, as properties with simpler transfer processes are often seen as lower-risk investments.
The cost approach assesses a property’s value based on how much it would cost to acquire the land and build the structure from scratch. Think of it as calculating the sum of land cost and construction expenses. For example, if a 1-acre lot costs $100,000 and constructing a retail center costs $1 million, the cost approach would value the property at $1.1 million. This approach often works well for new buildings, as it bases value on the property’s most productive use. However, it’s limited regarding properties expected to generate income since it doesn’t account for the revenue potential or nearby property prices.
In CRE, income potential is a powerful indicator of value, and that’s where the income capitalization approach comes in. This method, also known as the income approach, calculates value by analyzing expected income from rents and potential resale. This approach is ideal for investors focused on revenue-producing assets, like rental buildings or commercial centers, as it converts income potential into property value. Essentially, it allows you to see a property’s worth based on how much income it can generate in the market.
The sales comparison approach offers a grounded way to estimate value for properties with similar types nearby. Comparing recently sold properties in the area helps investors gauge a realistic price based on actual market transactions. This approach is widely used in residential and multifamily sectors, where properties with similar features can be compared. However, this approach may fall short with one-of-a-kind properties or markets with few comparable sales. It also doesn’t factor in vacancies or unexpected expenses, which can affect a property’s value.
The GRM approach provides a quick and straightforward way to estimate a property’s value based on its rental income. You multiply the gross annual rent by a multiplier for approximate value. For instance, if a property generates $100,000 annually in gross rent and the GRM is 8, the property’s estimated value would be $800,000. GRM is great for quick assessments but lacks the detail of other methods as it doesn’t account for expenses like maintenance or vacancy losses. It’s most effective as a supplementary tool.
Sometimes, simplicity works best, and that’s the idea behind the value-per-door method. This approach divides the total value of a similar property by its number of units (or "doors") to get a baseline value per unit. For example, if a 12-unit property is worth $3 million, each unit, or “door,” would be valued at $250,000. While handy for quick comparisons, this method doesn’t consider unit size, condition, or overall property quality, so it’s best used alongside other valuation approaches for a more comprehensive view.
The capital asset pricing model (CAPM) can be an option for those seeking more advanced techniques. CAPM evaluates a property’s potential returns by examining market risks and economic trends. Although commonly used for other assets, it’s gaining traction in real estate. However, CAPM is still relatively new in real estate and is generally suited for experienced investors comfortable with more complex analyses.
The correct valuation approach is essential in CRE, as an accurate valuation can make or break a deal. For sellers, setting a price too low risks leaving money on the table, while an inflated valuation could delay the sale by discouraging buyers, often resulting in a forced price reduction. For buyers, paying above market value can jeopardize the financial performance of the investment. A fair, well-researched valuation helps both parties reach a price that aligns with the property’s worth.
No valuation method works perfectly in every situation, so choosing the right approach is critical. For instance, a property might be valued based on its net operating income or by comparing recent sales of similar properties. Each method considers different factors, so the right choice depends on the property specifics, available data, and the objectives of the transaction. By selecting or combining methods carefully, we create a balanced, accurate assessment that benefits buyers and sellers.
Valuation isn’t one-size-fits-all — each situation demands a method that best reflects the asset’s potential. With over 30 years of experience and billions of CRE transactions, I bring the blend of market knowledge and strategic insight needed to determine valuations that work for both buyer and seller. Whether applying the income capitalization method for cash flow properties or the cost approach for new developments, my approach ensures smart, targeted decisions.
Investing with me means access to recession-resilient assets grounded in proven strategies for stability and high returns, as demonstrated by a 28% historical internal rate of return (IRR) across all asset classes. My experience and tailored approach help you unlock your investment potential and build lasting wealth. Learn more at BenReinberg.com.
