The most popular method of appraising commercial real estate is not the most accurate. Usually we compare past sales of property and apply the price per square foot, but this is valid only if all the properties are homogeneous, which is never the situation. This article examines three common methods of valuing commercial real estate and explains which method is best.
The most common method of valuing commercial property is the least accurate, because it only works if all properties have the same characteristics. Called the Sales Approach, it requires gathering the sales price of nearby comparable property, then making adjustments for different traits. This leads to inaccuracy, since the unique quality of real estate is that location can contribute greatly to how a property is used which determines what its value might be, and no two properties can occupy the same location. Other characteristics such as floor plan, parking, zoning, ingress and egress can also contribute greatly to value.
Sometimes, owners value real estate based on what they paid for it, or what someone last offered for the property, or the cost to build a new building. These valuation methods are always wrong. In reality, the market value has little to do with the cost of property, and an offer made by one buyer does not mean a different buyer would value the property at the same price. The market value is the price a property would bring in an open and competitive market, with a willing buyer and seller knowledgeable about the property condition. The cost approach only works when you have the time and financing plus a reliable contractor to build an identical structure on identical property.
Whether you own stocks or bonds or real estate, the best method of valuing an asset is calculating the present value of all future cash flows. The underlying principal is that a dollar one year from now is worth less than one dollar today, because you could invest that dollar today at some interest rate which will grow in one year to a value of more than one dollar.
Here is the math:
DPV=FV / (1+i)n where
- DPV is the discounted present value of the future cash flow (FV),
- FV is the nominal value of a cash flow amount in a future period;
- i is the interest rate, which reflects the cost of tying up capital
- n is the time in years before the future cash flow occurs.
Let’s put this information to work and say a property delivers $10,000 annually in cash flow after taxes. The current value is the sum of future cash flows. You calculate each year’s cash flow, discounted back at an interest rate you could earn on other investments. Let’s assume 7 years at a 5% interest rate and change the n value to match the number of years in the future.
In summary, $57,861 today is the same as $10,000 for 7 years, assuming 5% interest rates. Therefore, if a property had a 7 year lease that produced income of $10,000 annually, the current value of that lease income alone would have a value of $57,861. If an investor required a 10% rate of return, he or she would be willing to pay $578,610 for the property, just to get the lease income.
Not All Money Is The Same
Not all income is the same however. With commercial real estate, the best measure of income is called Cash Flow After Tax, which is the sum of these categories:
-Less Vacancy and Credit Losses
-Less Operating Expenses
-Less Annual Debt Service
-Less Tax Liability
=Cash Flow After Taxes
What Is Not Included In Operating Income
In calculating operating income after taxes, the category of operating expenses can often include and exclude various items that affect the value. For a realistic result, valuations should not include these expenses in determining operating expenses:
- Capital Expenses
- Personal Income Taxes
- Reserves for Repairs and Maintenance
- Tenant Improvements
- Real Estate Commissions
What Is Included In Operating Income
These expenses should be included when determining operating expenses:
- Property Taxes
- Management Expenses
In conclusion, the discounted present value is used to determine an asset’s value. Cash flow after taxes is used to determine the income streams. It’s just math.