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At its most basic level, the basis for taxation of commercial real estate (or any real estate for that matter) is value. In terms of managing a multi-property commercial real estate portfolio, value is the main variable determining an investor’s appetite for acquisition, disposition, or holding. If the market is down, opportunistic buyers may capitalize on a lower valuation to acquire properties, whereas a strengthening, or already strong market may be a signal to sell. But, if times are uncertain, given mixed economic news, and/or exogenous factors such as war, the best decision might be to hold. Of course, this is all predicated on a reliable estimate of a property’s value.
The importance of a proper valuation can’t be understated. In addition to providing a benchmark to use when buying or selling, financial institutions depend on accurate valuations to qualify buyers, provide financing, and secure insurance. Though several variables are considered when formulating value, there actually is no set formula for its calculation. Instead, a few methods are typically considered depending on the particulars of the underlying asset. This discussion document first summarizes some of the valuation methods often used (which are generally more applicable to residential real estate), but then we shift focus to the income method which is used most often in valuing commercial properties.
The timing here is significant. As we enter a period where increasing discrepancies in value between taxing authorities and property owners are taking hold, it is vital that portfolio owners have ready access to as many tools as possible when contesting tax bills. We know that itamlink is a key piece of that toolkit but being able to understand the rationale behind valuation is critical.
To begin, it is probably a good idea to demonstrate the underlying variability of valuation, which is best illuminated through this quote regarding a hypothetical residential anecdote from the real estate site Kiavi:
"Ultimately, the price that a (residential) property sells for may or may not accurately reflect its value. Imagine two identical homes, right next to each other. One sells for $200,000, similar to other neighborhood homes. The other sells for $100,000, from a father to his daughter–a price which has nothing to do with fair market value. Likewise, value and price often differ from a property's replacement cost. A beautiful 200-year-old home may have a $500,000 market value based on what current buyers are willing to pay, but if it burned down, it might cost $600,000 to build an identical replacement based on today's material and labor costs."
The question is, how does one rigorously evaluate their commercial real estate investments? No matter where an individual may be in the commercial real estate ecosystem – buyer, seller, investor, lender, or other – property valuation represents an essential piece of the puzzle.
Let us begin by summarizing some of methods often used in residential and some small commercial valuation:
One of the most popular valuation methods is based on simply examining comparable properties and their values.
Consider five residential properties built on the same street by the same builder in the same year using the same plans. When one of those properties is sold, it's easy to extend the value of that property to the others. They are essentially identical and thus can be valued the same. This is a bit of an oversimplification. Circumstances for identical comparison rarely present themselves, especially in the realm of commercial properties.
In the absence of perfect matches, appraisers will often make adjustments based on factors such as:
Sales comparisons are most appropriately applied to residential properties, even when those properties are purchased to rent or as an investment vehicle. The more comparable, similar properties nearby, the more accurate this method can be. This method is less relevant to larger-scale commercial real estate properties, such as office buildings, multi-unit apartments, condo complexes, and retail outlet strips, because of the variability of factors that must be considered.
This technique analyzes the land value of a subject property, estimating the cost components required to build the property from scratch, which is then adjusted for depreciation. It is most often used for relatively unique properties with few comparables. Examples include converted churches, rural buildings, and unique commercial properties.
After determining land value, structural value is estimated by tabulating new construction costs. Adjustments to the value of a new building are then made based on the actual building condition as well as additional costs associated with repairs or upgrades (e.g., installation of new HVAC or a roof). Other depreciation factors may include a reduction in the desirability of the property. For example, a strip mall located on a city's primary thoroughfare may drop in value after a new highway is constructed that diverts a significant amount of traffic away from that road/strip mall.
Though the cost method is logical, it can often be difficult to use, particularly in circumstances where replacement costs (especially of unique properties) is difficult to determine.
In addition to the methods discussed above, here is a summary of some alternative methods:
The Gross Rent Multiplier calculates a property's value based on the gross rent, ignoring expenses. For example, in a ten-unit building with each unit collecting $2,000 per month in rent, each unit would be worth $24,000 per year, or a total gross rent of $240,000 per year for the entire building. If a property is valued at $800,000, the gross rent multiplier is that value divided by the GRM, or about 3.4.
There are several valuation methods that use a quantifiable metric inherent to the property including:
Though relatively new, this model is typically used to calculate the rate of return on securities but is slowly being adopted by some real estate appraisers to value commercial real estate.
For commercial properties, the income method (also known as the income capitalization method) is generally the most applicable technique used when estimating value. At a high level, the income method is defined as the product of the amount of income a property generates divided by its capitalization rate (or “cap” rate), a term that will be explained in detail below.
The income method of valuation can be advantageous for an investor, as it provides them the incentive to create greater operational efficiencies in the assets or portfolios that are managed. For example, if owners can streamline the way routine maintenance is carried out, make capital upgrades to equipment, or take advantage of scale, costs can decrease, which in turn can boost net income.
For obvious reasons, this method tends to be the most popular for commercial real estate, given the fact most investors are incentivized to invest by the prospect of building income over time, knowing that the value based on income is the most important factor in making informed decisions regarding buying or selling.
The process begins by first determining net operating income or NOI, which is the total income generated by a property in a year, less expenses which might include items like insurance, utilities, maintenance, and property taxes. It is interesting to note that of all the items included in these components of additional rent, the most significant item is property tax, a variable that is actually the most controllable if the proper tools are used. We believe tools such as itamlink are game-changing in helping to manage the property tax component.
Using a rudimentary example, let’s assume we have a 10,000 square foot building that brings in a gross rent of $45 per square foot. For definition purposes, gross rent is the sum of net rent (the rent a building owner keeps) as well as an additional component referred to as either “Taxes, Maintenance, and Insurance (TMI)”, or “Taxes and Operating Costs (T&O)”. In this case, we’ll call the TMI $20 per square foot. Let’s also assume that the building is 95% leased. Here is how we calculate net income:
Once net income has been calculated, it is then divided by the cap rate.
Cap rates are typically defined as the calculation of the net operating income, divided by the current market value for the property, which can be based on an estimate of comparable properties. But this method still leaves us with a bit of a chicken or the egg conundrum in the sense that comparable properties may be difficult to identify, and if we are trying to determine an asset’s value – which is the whole point of this exercise – we need to know what the cap rate is.
Assuming we know the income and the cap rate, value is simply the income divided by the cap rate. Continuing on the example provided above, we determined the property has a net income of $237,500, and the cap rate is 5%, the value is $237,500/.05= $4,750,000.
No one, actually. Since the income method relies on income generated by the property, it is only helpful for properties that generate income. For example, an investor may purchase an abandoned building with the intention of refurbishing it over the next few years. In the interim, using the income method as a valuation tool wouldn’t be applicable. This technique is readily used when valuing apartment buildings, rental properties, and commercial properties, but not to standard residential housing.
Now, back to cap rate, and perhaps another, more understandable definition. In simpler terms, a cap rate is the percentage of value represented by one year’s net operating income. So, in the example above $237,500 represents 5% of the asset’s total value. Based on this, we can see the following general rule of thumb: the lower the cap rate, the higher the value of an asset.
For illustrative purposes, let’s assume this asset is located in a market where a large employer just announced they would be shifting their operations to another city. Over time, commercial real estate assets are trading for less, and the cap rates for that type of asset increase from 5% to 7%. What would be the impact on value? Firstly, the cap rate now says that “7% of the asset’s value in captured in its net operating income”. The value of the asset is now $237,500/.07 = $3,392,857.14, which is now $1.36M less than its value at 5%. The impact of even a small change in cap rates can be dramatic. Consider the example above where a 2% change in cap rates represents a drop in value of a staggering 28.5%!
With no central “exchange” responsible for tabulating and tracking cap rates (such as a central bank determining interest rates), investors use market data, or loose inside information (e.g. from a strong contact base of brokers) to derive estimates. Of course, coming up with these rates is a dynamic process which is subject to many variations including:
One of the emerging themes entering the post-pandemic period is investors’ contention that incomes are down based on higher vacancy rates, combined with the turnover of leases. The precision the income method can afford in making property tax appeals lends precision and is thus invaluable.
Establishing the value of a commercial real estate asset is the foundational basis for buying, selling, and operating real estate. Given its importance, combined with the fact there really isn’t a central clearinghouse for determining price, it becomes necessary that those in charge of valuation adopt robust methods to estimate the correct price of an asset. In this brief, we have reviewed several commonly deployed techniques, but have placed particular emphasis on the income model, given its applicability to commercial real estate assets.
The issue of valuation has a direct and important linkage to property tax, as the amount a property owner eventually pays in property taxes is a function of that valuation. The income method considers two important variables, net operating income and capitalization rates. The largest expense item related to NOI is property tax, being able to be precise and timely in its estimation feeds into the entire valuation ecosystem.
When reviewing tax, it is important you adopt itamlink as a tool that will ensure this process is complete.
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