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Property Value

Step-by-Step Guide to Understanding Property Value

  Updated Feb. 20, 2024
  13m Read Time

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Property Value

  Table of Contents

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.

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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
  • The sales comparison approach (SCA), one of the more intuitive methods to value a property, involves compiling data regarding the recent prices paid to purchase comparable properties in the same location and using either the mean or median as a benchmark to guide pricing.
  • Other internal factors to consider include the size of the property (e.g. sq. footage), the number of bedrooms and bathrooms, amenities, property condition (i.e. repairs), etc.
Income Approach – Direct Capitalization Method
  • The income approach, frequently used in the commercial real estate (CRE) market, estimates the value of properties based on their implied revenue potential and capitalization rate (or “cap rate”).
  • Initially, the net operating income (NOI) of a property is calculated, and then the property’s NOI is divided by its cap rate to arrive at a property value estimate.
  • Note that there is much overlap between the sales comparison approach and the income approach.
Income Approach – Gross Rent Multiplier (GRM)
  • The gross rent multiplier (GRM) method is often categorized under the income approach.
  • The GRM method determines the market value of a property by multiplying the gross rent multiplier (GRM) by the property’s annual gross rental income.
  • The formula to compute the GRM divides the sale price of a property by its annual gross rental income, which can be rearranged to isolate the price variable.
  • However, the GRM method is more of a “back of the envelope” property valuation method that precedes a more in-depth analysis.
Cost Approach – Replacement Cost Method
  • Under the cost approach method, the approximate value of a property is calculated by estimating the total cost incurred to replace (i.e. the replacement value), or “rebuild” the asset(s) from scratch.
  • The included costs are items such as land costs, labor expenses, and construction expenditures.
  • In comparison to the income approach, the cost approach is less prevalent, as the method is usually only used if recent sales data is limited, or if the property has been non-operational.
DCF Analysis
  • Building a discounted cash flow (DCF) model to value a property starts by projecting the future free cash flow to equity (FCFE) of the real estate project and then discounting them back to the present date – i.e. the original date of purchase – using an appropriate discount rate.
  • Since the cash flow projected is free cash flow to equity (FCFE), the coinciding discount rate to use is the cost of equity.
  • The magnitude of the discount rate should reflect the risk-return profile of the property investment, or said differently, the target internal rate of return (IRR) of the investor.
  • The implied property value derived from the DCF represents the price that the investor should be willing to offer to proceed with the investment, i.e. the potential return validates taking on the project’s risk.
  • While the DCF approach is far more common in valuing non-real estate corporations – as opposed to real estate properties (and REITs) – the method can still technically be used here.

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.

Zillow Zestimate Property Value

“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.

Property Value, Capitalization Approach = Net Operating Income (NOI) ÷ Cap Rate (%)

Where:

Net Operating Income (NOI) = Effective Gross Income (EGI) – Direct Operating Expenses
Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses

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.

Cap Rate (%) = Net Operating Income (NOI) ÷ Property Value

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.

Property Value, Gross Rent Multiplier (GRM) = Annual Gross Rental Income × Gross Rent Multiplier (GRM)

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.

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Commercial Real Estate Property Value Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Commercial Real Estate Property Assumptions (CRE)

Suppose a real estate investment firm is considering a potential acquisition of a commercial office building.

If acquired, the property expects to generate $2 million in potential gross income (PGI), with vacancy and credit losses expected to be 5.0% of PGI.

  • Potential Gross Income (PGI) = $2 million
  • Vacancy and Credit Losses (5.0% of PGI) = 5.0% × $2 million = $100k

Given those figures, we can determine the effective gross income (EGI) by subtracting the expected vacancy and credit losses from the property’s potential gross income (PGI), which is $1.9 million in our scenario.

  • Effective Gross Income (EGI) = $2 million – $100k = $1.9 million

2. Net Operating Income (NOI) Calculation Example

The next step is the calculate the property’s net operating income (NOI) by subtracting its effective gross income (EGI) from its operating expenses.

For our hypothetical scenario, we’ll assume the property’s direct operating expenses are 40% of EGI.

  • Operating Expenses = 40% × $1.9 million = $760k

The commercial building’s net operating income (NOI) is the difference between its effective gross income (EGI) and operating expenses, which is approximately $1.14 million here.

  • Net Operating Income (NOI) = $1.9 million – $760k = 1.14 million

Note: In more complex real estate financial models – most often for commercial properties – the “Replacement Reserves” is a common line item that further reduces the net operating income (NOI) metric.

3. Commercial Property Value Calculation Example

The only remaining assumption necessary to perform a property valuation using the income approach is the capitalization rate (or “cap rate”).

To restate from earlier, the cap rate applied is contingent on the fundamentals of the property and comparable properties in the same or adjacent market.

In our illustrative model, we’ll set up five different scenarios using a step function (+1.0%), in which the only difference is the cap rate.

  • Cap Rate (%) – Scenario A = 6.0%
  • Cap Rate (%) – Scenario B = 7.0%
  • Cap Rate (%) – Scenario C = 8.0%
  • Cap Rate (%) – Scenario D = 9.0%
  • Cap Rate (%) – Scenario E = 10.0%

The estimated property value under each scenario is calculated by dividing net operating income (NOI) by an appropriate cap rate derived from analysis of comparable properties and market analysis.

Property Value = Net Operating Income (NOI) ÷ Market Cap Rate (%)

Cap Rate Property Value Calculation Example

4. Commercial Real Estate Appraisal Example

Once the NOI and cap rate figures are computed for each scenario, we arrive at the following property value estimates.

  • Property Value – Scenario A = $1.14 million ÷ 6.0% = $19.0 million
  • Property Value – Scenario B = $1.14 million ÷ 7.0% = $16.3 million
  • Property Value – Scenario C = $1.14 million ÷ 8.0% = $14.3 million
  • Property Value – Scenario D = $1.14 million ÷ 9.0% = $12.7 million
  • Property Value – Scenario E = $1.14 million ÷ 10.0% = $11.4 million

Therefore, our modeling exercise illustrates the fundamental relationship between the cap rate and property value estimates, where rising cap rates cause implied property prices to decline due to the higher risk profile.

Property Value Calculator

What Affects Commercial Real Estate Property Valuations?

The factors that influence the property value in a specific real estate market include the following:

  • Market Conditions (Supply-Demand) → From a high-level perspective, the main factor that causes a change in real estate property values is market demand. If market demand increases, property value prices tend to rise in tandem, and vice versa if demand in the market declines.
  • Inflation → Inflation is the economic state where the general prices of goods and services rise, often due to excess money in circulation. The excess supply in the markets causes the currency to devalue, in which the purchasing power of consumers declines. Given the increase in pricing of general consumer goods amid inflationary periods, a slowdown in the real estate market often follows suit from the widespread fears of a potential recession on the horizon, as well as higher input costs (e.g. construction supplies). Hence, new construction activity has historically experienced significant declines in past recessions, while defaults on home loans spiked.
  • Interest Rate Environment → The current interest rates in the credit markets and the ease of access to “cheap” debt financing are correlated to the total transaction activity in the real estate market. If the cost of borrowing rises, the demand for home purchases tends to decline, as fewer consumers can afford to purchase homes considering the higher cost of borrowing. On the other hand, declining interest rates are favorable to buyers in the real estate market as sentiment improves, and more loans priced at lower rates are offered to finance the purchase of properties such as homes.
  • Location and Proximity → The properties located in densely populated cities, most often urban areas such as New York City (NYC), Boston, Los Angeles, and Miami in the U.S., receive higher valuations because of strong market demand. Moreover, the proximity of the property to educational institutions (e.g. high schools, universities), the workplace (e.g. offices), transportation, and other amenities (e.g. food markets, shopping malls) can impact property values in specific areas. For instance, the properties in New York near the NYC Transit (MTA) fetch higher prices, because buyers (and tenants) are more willing to pay a premium for the convenience of living near the public transport system, i.e. to avoid prolonged commutes.
  • Safety and Security (Crime Rate) → Safety can be a top priority for many consumers, especially those with families. For that reason, properties located in safer neighborhoods frequently mention their low crime rates in their marketing efforts to drive demand, as well as their measures to ensure safety (e.g. modern emergency response system, security alarms, gated community).
  • Design and Layout → Certain properties are often designed to cater to a niche demographic, which can cause prices to rise since the layout is uncommon. The limited supply in a market results in higher property valuation because of the target market’s willingness to pay a premium, i.e. the concept of “scarcity value”.
  • Current Condition of Property → The current condition of the property influences property value. For example, a buyer could negotiate a discounted purchase price based on the notion that repairs are required post-sale. Furthermore, outdated features that trail behind comparable properties, such as a worn-out A/C system, can have negative implications on market demand (and sale price).
  • Sales Comparison → The recent sale prices of comparable properties in the same (or adjacent) area often provide useful insights on the appropriate pricing. Therefore, buyers and sellers often reference past transactions in negotiations regarding how much a property is worth.

External vs. Internal Factors: What is the Difference?

Often, external factors at the macro level are the main catalyst for material changes in property prices in the real estate market, but internal factors can also contribute to pricing fluctuations.

  • External Factors → As a real-life example, property prices in Florida and Texas surged post-2020 due to factors such as a more favorable tax structure, political matters (e.g. safety), a relatively lower cost of living, the work-from-home (WFM) trend, and more corporations moving to the Southern region of the U.S. (i.e. more job opportunities). Meanwhile, property prices in areas like San Francisco plummeted in the same time horizon, namely due to the rising crime rate and pent-up frustrations around governance.
  • Internal Factors → For instance, a homeowner could decide to implement property improvements like pool installation, repairs, and maintenance, upgrade the property with modern appliances, and implement other value-add initiatives to modernize the house, which are all factors likely to contribute to a higher property value (and sale price).

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