No matter where you sit in the value chain, you need a reliable way to determine commercial real estate property value. Further, you need to arrive at this value independent of influence from brokers, partners, sponsors, and consultants.
Your real estate business depends on you having a unique perspective on historical, current, and future value.
My perspective was formed over many years in the business. Below is a glimpse into my process, but I encourage you to explore other ways to establish value.
Comparable Property Transactions
The most common way to establish the value of one property is to collect and examine all recent transactions of similar properties. This method gives you a perspective on what active buyers are looking for in a similar property.
Assuming you are operating in a relatively liquid market, the comparable transactions approach makes a good bit of sense. However, consider the nuances to amplify your success here.
Some markets are very thin. Meaning, they don’t have many transactions of similar properties. In that case, you have to logically expand your criteria.
For example, suppose the subject property is a Courtyard by Marriott and the only select service hotel in the county. You may want to segment your comparable transaction analysis into multiple parts: 1) all hotel sales in a reasonable market area and 2) all Courtyard by Marriott hotel sales in the region.
Similarly, you may be active in a market with many refinance transactions but only a few sales. Because lenders require appraisals, you can consider the refinance value a good estimate of the true real estate property value.
Replacement Cost
Real estate has tangible value, which is one of the best reasons to invest in this asset class. It’s important to capture that when evaluating the value of a property.
The cost to rebuild and re-tenant a building is known as the replacement cost.
Each stakeholder has a different perspective on what should be included and how to use it as a benchmark against the subject property. For example, an insurer uses replacement cost to examine what a total loss would look like. Investors use this to understand entry barriers against new supply so long as market transactions are happening below replacement cost.
I like to include everything in my estimate because we’re using this to establish real estate property value holistically. That includes land and financing costs.
- Land
- Hard Costs
- Soft Costs
- Furniture, Fixtures, and Equipment
- Pre-Opening Expenses
- Financing Costs
This provides a complete picture of what you or a competitor would encounter when entering this market.
Future Cash Flow
The snooty among us use the mathematical complexity behind discounted cash flows (DCF) to keep people out of our space or promote our intelligence. However, it’s a very simple set of concepts in reality.
A DCF model takes your projections of future cash flow and distills it to a single number. The math behind this is somewhat complicated, but Excel or Google Sheets do the calculations very easily for you using the NPV or IRR functions.
NPV (net present value) uses your target annualized rate of return to establish the purchase price.
IRR (internal rate of return) uses your purchase price assumption to establish the annualized rate of return.
Historical Cash Flow
Historical cash flow is useful on two levels – revenue and profit.
Each asset class has its own rules of thumb regarding how to establish real estate property value from revenue. Most cases use a multiple on rental revenue known as the gross rent multiplier (GRM).
Property Value = Annual Gross Revenue * GRM
It’s up to you to determine what revenue you include here, as some asset classes have more ancillary revenue than others.
On profitability, we use the inverse of the EBITDA multiple that you commonly find in stocks. In this case, we take the property’s historical income statements as the basis. Modify expenses appropriately to establish a “true” net operating income (NOI), then apply a market or target capitalization rate (cap. rate) to establish the real estate property value.
Property Value = Adjusted NOI / Cap. Rate
Reconciliation
All this hard work gave you five numbers from the following valuation approaches:
- Comparable Transactions
- Replacement Cost
- Discounted Cash Flows
- Gross Revenue Multiplier
- Capitalization Rate
Your goal is to get a single number, though.
That’s where reconciliation comes in. You need to bring all these together and apply a relevant weight to each one. This is purely subjective, but it’s important to have some methodology behind your assumptions.
Your weighting will be a number between zero and one or 0% to 100%. Regardless of your approach, all the weights should add up to 1 or 100%, respectively.
Multiply the values by their weight, and then add up all the weighted values to get a fully reconciled real estate property value.
Most people don’t go through this comprehensive exercise until further down the road in their underwriting process, which I think is totally reasonable. Still, I think it’s a valuable exercise to learn the “ins and outs” of commercial real estate valuation.