What is Property Value?
The Property Value is the estimated fair market value (FMV) of a real estate property, such as a commercial office building, as of the present date.
Table of Contents
- How to Calculate Property Value in Real Estate
- What are the Commercial Real Estate Appraisal Methods?
- Property Value Formula
- Commercial Real Estate Property Value Calculator
- 1. Commercial Real Estate Property Assumptions (CRE)
- 2. Net Operating Income (NOI) Calculation Example
- 3. Commercial Property Value Calculation Example
- 4. Commercial Real Estate Appraisal Example
- What Affects Commercial Real Estate Property Valuations?
- External vs. Internal Factors: What is the Difference?
How to Calculate Property Value in Real Estate
The property value of a real estate asset, such as a commercial building or office space, is the estimated price at which a property can be sold in the open markets.
Broadly put, the estimated market value ascribed to a specific property is determined by the market demand and supply available at the present date.
- Market Demand → The amount of interest from potential investors (and buyers) in the market to purchase or acquire real estate in a specific market.
- Market Supply → The amount of real estate (e.g. properties, land) available for sale in the market.
If the market supply remains constant while market demand increases, the property values in the market should expect to rise, all else being equal.
Therefore, property values constantly fluctuate based on the current balance between market demand and supply, among other factors such as the interest rate environment (i.e. the cost of borrowing).
For a property value estimate to hold weight, the property must have been marketed transparently – i.e. via non-deceptive marketing or concealing material information influential on the fair value of a property – such as leaking ceilings or damages.
The two parties involved in the real estate transaction – the buyer and the seller – must have both acted with knowledge of all material information regarding the property, without compulsion and formally agreed to the sale on their own accord.
Forced Sale Example
If a homeowner is abruptly forced to sell their property to avoid defaulting on a business loan unrelated to the property itself, the “fire sale” nature of the transaction (and expedited process) causes the sale price to not reflect the true fair value of the property.
The buyer in the transaction, in all likelihood, purchased the property at a steep bargain, at the expense of the seller, akin to distressed asset sales in corporate restructuring.
What are the Commercial Real Estate Appraisal Methods?
In practice, there are various appraisal methods to determine the valuation of a property.
The following table outlines the most notable appraisal methods used by practitioners:
| CRE Appraisal Method | Description |
|---|---|
| Sales Comparison Approach |
|
| Income Approach – Direct Capitalization Method |
|
| Income Approach – Gross Rent Multiplier (GRM) |
|
| Cost Approach – Replacement Cost Method |
|
| DCF Analysis |
|
Irrespective of the methods used to estimate the value of a given property, an independent 3rd party appraisal is often recommended for larger-sized real estate projects, alike a fairness opinion in M&A, to ensure the price paid is reasonable.
The certified appraiser is hired to provide an independent property valuation, mitigating the risk of potential mispricing caused by a potential conflict of interest (or any inherent bias).
The appraiser conducts an in-person inspection of the property, including diligence on the surrounding location, market trends, and comparable properties.
In recent times, automated tech-based platforms, such as Zillow and Redfin, have emerged that can estimate the price of properties.
Yet, these pricing quotes are not meant to replace a formally recognized appraisal. Instead, the estimated property values are more akin to a “quick comps” analysis and should not be taken at face value, although the algorithms have unquestionably improved in accuracy in recent years.
“How Accurate is the Zestimate?” (Source: Zillow)
Property Value Formula
Under the income approach, or “capitalization approach” – the focus of our post on conducting a commercial real estate (CRE) appraisal – the property value formula is as follows.
Where:
The cap rate (%) component is determined based on the risk-return profile of the property and other factors, such as comparable properties and current market conditions.
Therefore, while the capitalization rate can be calculated using the following formula, the cap rate input in our property value formula is not a direct calculation, but rather at the discretion of the real estate investor.
But for general reference, the cap rate formula is as follows.
The appropriate cap rate to apply in the valuation of a given property is derived from comps analysis, i.e. the investor analyzes the cap rates of comparable properties.
Generally speaking, a higher cap rate implies there is more risk attributable to undertaking a certain real estate project, which coincides with a lower property value because investors in the market require a higher potential yield to compensate for the incremental risk of an investment.
The other income approach – the gross rent multiplier (GRM) method – uses the following formula.
Unlike the capitalization approach, the GRM method uses the property’s annualized gross rental income, rather than the net operating income (NOI).
That said, the operating expenses incurred by the property – e.g. property taxes, insurance, repairs or renovations, and utility bills – are neglected.
Like the cap rate, the multiplier applied is based on performing diligence on the property and comps analysis.
