How Commercial Real Estate is Valued
How much is the commercial property you’re investing in actually worth, and how is that number calculated?
In particular, you should always take a closer look at the property’s valuation, because the process for determining the value of commercial real estate is not entirely objective. There are many factors that impact a property’s value, and different factors will be prioritized depending on the valuation method a sponsor uses.
Common Methods for Property Valuation
For the purpose of this article, we’ll look at three of the most common approaches people use to determine the value of commercial properties, and the pros and cons associated with each.
The cost approach estimates how much it would cost to replace the existing property, factoring in the value of the land and the amount it would cost to build the structure from the ground up in today’s economy.
Other approaches focus heavily on capitalization rates, or the expected rate of return on a real estate investment. To calculate a property’s cap rate, you simply divide the expected annual net operating income by the property’s current value. If a cap rate is particularly high, that may indicate that the property is undervalued. In general, cap rates are most useful when dealing with stable assets that have a predictable net operating income over time.
As its name suggests, the sales comparison approach focuses on looking at the value and performance of similar assets in the same market. Factors considered may include price per square foot, price per unit, operating income, and tenant profiles.
Each of these approaches can serve as a helpful data point as you’re conducting due diligence, but it’s important to also understand their limitations.
The cost approach does not factor in the property’s potential to generate long-term cash flow in the future. The effectiveness of sales comparisons almost entirely depends on whether recent comparables even exist in the local market. And cap rates, while useful for understanding an investment’s risk level and projected returns, do not account for inflation or leverage.
Because of this, it’s important to not rely too heavily on any one approach, but rather look holistically at the property’s current value, potential for cash flow and appreciation, and expected performance in a variety of market conditions.
Our Strategy at Excelsior Capital
At Excelsior Capital, we’ve chosen to focus on commercial assets in secondary markets with strong underlying economic fundamentals. These assets are often undervalued and overlooked by larger institutional groups. Additional factors that are important to evaluate are:
- Weighted average lease term: The average amount of lease time remaining for all current tenants
- Occupancy history
- Submarket location
We also prioritize asset classes that are durable through periods of recession and have uncorrelated cash flow and upside. This sets us apart from some other investment sponsors who prioritize higher returns but do so by investing in more volatile asset classes.
Remember: just because a deal has a higher-than-average projected ROI does not necessarily mean that it’s a better investment than another deal that has a lower ROI but is located in a strong market or is part of a more stable asset class.
Partner with an Experienced Sponsor
While it’s always important to conduct due diligence before making an investment, working with a sponsor you know you can trust will help eliminate some of the question marks around a property’s valuation and the returns it’s expected to generate.
This is one of the key benefits of co-investing in commercial real estate with a company like Excelsior Capital. We do all the heavy lifting of sourcing deals and then presenting them to our prospective investors. And after a deal is completed, investors can count on us to handle all reporting, property management, and investor relations, while providing you with full transparency through our investor portal.
If you’re interested in learning more about our direct investment opportunities, please fill out this form to get in touch with our team.
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A real estate private equity firm that owns and operates high quality multi-tenant office assets in emerging secondary markets.
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Disclaimer: Under no circumstances should any information presented on this website be construed as an offer to sell, or solicitation of an offer to purchase any securities or other investments. This website does not contain the information that an investor should consider or evaluate to make a potential investment. Other materials related to investments in entities managed by Excelsior Capital are not available to the general public.