A commercial property's value is the amount agreed to in a transaction between a buyer and a seller. Both parties engage in a valuation process to negotiate a fair sales price based on the property's utility, estimated income, and recent similar transactions in the area. One of the more popular valuation techniques is income-based, which considers a property's net operating income (NOI), estimated expenses, and capitalization or cap rate.
Property valuation affects more than just the sales price. It can influence property tax assessments, which authorities use to calculate annual property taxes. This guide explores the basics of how to value a commercial property.
Overview of Common Valuation Methods
Let's examine the three standard approaches used to value commercial properties. We'll use the Atlanta office market as an example. Assume there's an office building in downtown Atlanta for sale. It's fully occupied with six tenants and 10,000 square feet of space.
Income Approach (Income Capitalization)
The income approach calculates a property's value based on estimated future income, expenses, and capitalization rate. Investors apply a cap rate based on recent sales of similar properties or by using the property's current value.
To find the value of a commercial property based on rental income, use this formula:
Net Operating Income / Capitalization Rate
For instance, assume the Atlanta office building's six tenants pay $150,000 in annual rent. Expenses for building maintenance, property taxes, utilities, and debt services are $30,000. You estimate a cap rate of 5% based on recent sales of nearby office buildings.
The valuation is $2,400,000, or ($150,000-$30,000) / .05.
Cost Approach
Under the cost approach, an investor considers the value of a commercial property's land and the cost of rebuilding it from scratch to determine its valuation. The total of both represents its valuation.
Continuing with our example, say the Atlanta property's land value is $400,000. It's 10 years old and three stories tall, with several elevators and modern amenities. Estimates to rebuild it are $1,950,000. The total valuation is $2,350,000, or $400,000 + $1,950,000.
Sales Comparison Approach
Sales comparison methods establish a property's valuation by referencing recent sales of similar properties in the area.
To calculate the value of a commercial property, investors adjust for differences in the comparison properties, such as square footage and general condition.
Consider the hypothetical Atlanta office building. Within a one-mile radius, there have been six recent sales of similar buildings. The average sales price among the properties is $2,200,000.
However, the office building you're considering is 5% larger than the other properties and two years younger. Under the sales comparison method, a valuation of $2,375,000 might be reasonable.
Key Factors Affecting Property Value
The methods used to value a commercial property may seem relatively straightforward. However, it is actually a rather complex process. Numerous factors can influence valuation calculations.
Location and Market Trends
A property's location can significantly inflate or deflate its valuation. For instance, a downtown office building in a busy area might command a higher price than a similar building in a rural small town. Market trends, including shifts in buying patterns and recent property sales, also contribute to valuation swings.
Property Condition and Improvements
Newer commercial properties typically do not require significant repairs, whereas older properties often do. Investors consider the property's age and overall condition when valuing it.
If the property requires considerable maintenance to enhance its utility, that cost is factored into the final valuation. Properties with recent improvements can also command a higher value.
Step-by-Step Guide to Property Valuation
Here are the steps a certified and licensed appraiser takes to find the value of a commercial property.
1. Initial property assessment
The appraiser reviews basic information about the property, such as its income statements, recent renovations, and property tax details. They'll schedule a site visit to view the property in person and photograph its features and general condition.
2. Selection of an appropriate valuation method
Most appraisers use the income approach to value commercial properties. However, they may opt for a different method depending on the circumstances. For example, a cost approach might make sense if there are few other similar commercial properties in the area.
3. Analyzing market data and trends
This is the most time-consuming part of the valuation process. The appraiser considers the property's potential income based on market trends and history. They may use databases to access historical public records, area demographics, and zoning information.
4. Final valuation calculation
Once the appraiser completes the valuation, they'll share it with you. The final package includes a valuation and an explanation of the calculation process.
How Property Valuation Impacts Property Taxes
Government entities impose property taxes as a primary source of revenue for essential services, including public schools, police and fire protection, and road maintenance. Each state or locality sets a property tax rate, which it applies to a property's value to determine total taxes owed.
Most states rely on an assessed value to calculate commercial property taxes, not the valuation appraisal used for buying and selling. The assessed value may be less than its market value or valuation. Governments typically determine assessed values using a statistical model. Some may collect information about an income-producing property to apply an assessed value using the income approach.
If you're an investor considering a commercial property purchase, review local laws to understand how authorities perform assessments. If the government uses the income approach, the valuation completed by your appraiser may closely align with the assessed value from tax authorities.
Additionally, some governments offer incentives that lower the assessed value of a commercial property. For instance, a locality might provide an abatement on property taxes to encourage more investment.
An exemption might also be available for properties that meet specific environmental requirements. Taking advantage of available exemptions can lower the assessed value of the property and your tax burden.
Effectively Manage Your Property Taxes With Ownwell
Ownwell helps commercial property owners reduce their property taxes and apply for available property tax exemptions.
Our team services nearly all types of commercial properties, including multifamily, office, retail, and industrial.
To explore how Ownwell can help you improve your commercial property's NOI, speak with sales today!
