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Given enough time all real estate deals are profitable, however it is a known fact everyone loses money in real estate at some point. But in order to mitigate your risk, how do you determine how much to pay for a property?
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How To Value Commercial Real Estate
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| By Gary L. Smith |
How do you decide what a building is truly worth both in today’s market and at some point in the future?
How do you know what a property is really worth?
There are basically three ways to evaluate real estate. The Sales Comparison method, commonly referred to as “comps” is primarily used in residential real estate. Basically you determine the value of one property in a given area by the sales of similar properties within a specific time frame, typically six months.
Another approach to determining value is the Replacement Cost method. Whenever you use this approach you must find out how much does it costs, to build a brand new building with the same quality of materials, location, etcetera, as the one you’re buying. It’s generally acceptable if your costs are lower than the cost to build new.
Then there is the Capitalization method (CAP Rate). This method is used over 90 percent of the time when it comes to commercial real estate, because what you are buying is an income stream. By taking the income of a property and dividing it by the price you arrive at the Capitalization or CAP Rate.
Another way of looking at cap rate is that if you were paying all cash for a property, then the cap rate is the actual return you’re receiving on your investment. Knowing the cap rate in a particular market or for a particular property type is critical to determining value.
This column will focus on the Capitalization Method or what I like to call the Income Approach. The income approach to valuing a building is used to determine whether you can make money or not, before you even see the property.
