Appraisers use three general approaches to value properties.
The cost approach looks at what it would cost to replace a building while the sales comparable approach looks at what similar properties sell for and adjusting the market data to come up with an accurate value for the property.
The income approach applies a multiplier, called a capitalization rate, to its income. This approach is usually most appropriate for income producing commercial properties.
Calculating the Income
The income approach only works if you have an accurate “net operating income” for the property. To calculate the NOI, start by annualizing the property’s rental income and subtracting a vacancy factor that is appropriate for your market to find the “effective gross income.” For example, if the building is full, you would subtract 5 percent of the rent for vacancy.
Add up all of the property’s annual operating expenses and subtract them from the EGI to find the NOI. Operating expenses include normal recurring expenses that are tied to the building, such as property taxes, utilities, non-capital repairs, and management.
They don’t include capital expenditures, the cost of leasehold improvements or landlord expenses such as mortgage payments.
Conducting Market Research
Before you can find a value based on the NOI that you calculate, you must select a capitalization rate based on market sales comparable.
To find an accurate cap rate, research recent sales of similar properties in the market. For example, if you’re valuing a 50,000 square foot class-B office building in San Rafael, you might want to look at any building between 25,000 and 100,000 square feet that sold anywhere in Marin County.
Third-party data sources such as CoStar or LoopNet can be helpful, and you can also get sales data by calling a county assessor, looking at research reports from local commercial real estate brokers, or working directly with a broker.
Deriving a Cap Rate
Once you have derived a cap rate based on market research, you will need to adjust it slightly for your property. For instance, if your property has higher-quality tenants than other properties that have changed in your market, you might reduce the cap rate slightly.
On the other hand, if your property is less attractive than others that have changed hands, increase the cap rate slightly. Generally, you will want to set a cap rate that is within 50 basis points of the market norm. For example, if the average market cap rate is 7.25 percent, you would probably value your property between a 6.75 and a 7.75 percent cap rate.
Once you have a cap rate, divide the property’s NOI by it. For example, if your property has a $650,000 NOI and you select a 7.25 percent cap rate, it would be worth approximately $8,966,000.
Confirming the Value
As a part of your research, you probably also came across some other valuation metrics, such as a price per unit for a multi-family property or a price per square foot for a leased property such as an office or industrial building or retail center.
If the price per square foot for your building is reasonably close to the market price per square foot, it can serve as a confirmation that your price is reasonably accurate.
Perhaps the best approach to take at this point if you are unsure how to properly assess the value of your property is to hire an appraiser. Appraisers in the San Francisco area can be found relatively easy using a simple web search.