Are you a commercial real estate (CRE) investor or a finance professional tired of playing the guessing game when it comes to property valuation? Do you sometimes feel like you’re throwing darts in the dark, hoping to make the right investment decisions—only to discover that the real-world numbers don’t add up?
You’re not alone. Most investors and professionals in the CRE space find property valuation and due diligence to be one of the most challenging aspects of their business.
Property valuation is both an art and a science.
It helps investors and CRE professionals make the right investment decisions using their knowledge, skills, and even gut feelings to determine how much a property is worth. At the same time, it needs data and concrete figures to back it all up.
This is where valuation modeling comes into play.
Valuation modeling has proven to be a game-changer in CRE. It provides crucial insights into real estate investments and helps industry professionals make informed decisions backed by data and analytics.
This guide will explore why valuation modeling is the secret sauce in successful commercial real estate investments and risk management.
Discover how AI tools like Blooma can take the guesswork out of property valuations, and how it brings more accuracy and confidence to your CRE investments.
What is Property Valuation Modeling?
Property financial modeling estimates the current worth of potential property investment. This practice helps investors compare different investments and make informed decisions based on accurate financial information rather than relying solely on the price of a given property.
The primary purpose of valuation modeling is to assess the intrinsic value of a potential investment. This assessment helps investors identify market trends, predict future returns, determine the property’s present value, and make intelligent investment decisions.
Valuation models can be used for residential and commercial real estate investments. The main difference is that commercial valuations are often more detailed and complex due to the significantly larger size of these investments.
Primary Elements of Property Valuation
Four primary elements influence the numbers that come out of property valuation—demand, utility, scarcity, and transferability.
The demand for a property is directly proportional to its value in the market, which ultimately impacts its relative valuation.
A high-demand property often signifies a strong market—attributed to an attractive location, favorable economic factors, or unique features.
In contrast, a property with low demand may struggle to maintain its value, ultimately affecting its overall valuation.
Utility reflects the property’s ability to meet the wants and needs of prospective owners.
A property with a high degree of utility will likely attract and retain potential buyers with diverse needs, thus increasing desirability and higher valuation.
Factors that contribute to a property’s utility include:
- Suitability for intended use
- Ease of access
- Availability of amenities
- Potential for customization
- Adaptability to different uses
Scarcity is a fundamental principle of economics that applies directly to property valuation. The availability of a commodity in relation to its demand influences its value.
In property valuation, identifying areas with limited supply and high demand can give investors insights into potential growth areas and long-term sustainability.
As the availability of comparable properties decreases, the value of a scarce property typically increases. The uniqueness of the property, combined with a limited supply in the market, can result in a higher valuation and strong demand from potential buyers.
Transferability refers to how easily ownership rights can be transferred.
Factors such as clear title, established boundaries, and regulatory compliance contribute to the transferability of a property, potentially enhancing its value.
A property with clear and easily transferable ownership rights is more attractive to potential buyers, resulting in higher demand and, subsequently, a higher valuation.
Metrics Used in Property Valuation
Here are some of the metrics commonly used in appraisal methods:
Capitalization Rate: Commonly called the “cap rate,” this metric measures the rate of return on a real estate investment based on the expected annual net operating income (NOI) and the property’s purchase price or value. A higher cap rate signifies greater risk and potentially higher returns, while a lower cap rate implies lower risk and potentially lower returns. It provides investors with a benchmark for comparing real estate assets.
Net Operating Income (NOI): NOI is the annual income generated from a real estate property after deducting all operating expenses, such as property taxes, maintenance, and management fees, but before accounting for debt servicing costs like mortgage payments (which is considered finance, not operating, expense). NOI represents the property’s ability to generate profits and serves as a critical metric to evaluate the property’s financial performance. A higher NOI indicates a valuable asset with a solid income-producing potential, and investors usually aim to maximize this metric to achieve better returns on their investments.
Rental Rate: Rental rates are crucial in determining the property’s overall valuation as they impact the capitalization rate and net operating income. It refers to the amount a tenant is willing to pay for leasing the property, and it varies depending on factors like location, property size, and market conditions. Higher rental rates generally suggest a property is in a desirable area and can command higher rents, driving up its overall value.
Lease Terms: Lease terms determine the period for which the rental income is secured. Longer lease terms can provide more stability and predictability for investors, contributing to a higher valuation. Key elements of lease terms include length, tenant credit quality, and lease structure, such as gross or net leases.
Tenant Improvement (TI) Allowance: TI allowance is the amount a landlord is willing to contribute towards customizing or fitting out the leased space to meet the tenant’s specific needs. These improvements can range from cosmetic changes to structural alterations. A higher TI allowance is usually associated with a more adaptable and valuable property. It signifies the landlord’s commitment to retaining and attracting quality tenants, which impacts rental income and NOI.
Rent Escalations: Rent escalations are built-in provisions in lease agreements that lead to periodic increases in rental rates, ensuring the rental income keeps pace with market trends and inflation. Evaluating rent escalations can significantly impact a property’s NOI and overall valuation over time. Different types of rent escalations include fixed-rate increases, indexed escalations tied to inflation or economic indicators, and market-driven escalations based on comparable leasing activity in the area.
Why Is Valuation Modeling Important?
Valuation modeling is crucial in real estate investment as it aids investors in the following:
Informs Decision Making
Investors are better equipped to forecast the expected return on investment, analyze future cash flows, and measure overall financial performance. They can then make strategic decisions when comparing various investment opportunities, ultimately leading to a more profitable and sustainable investment portfolio.
Valuation modeling also assists in establishing a property’s true market value, enabling investors to negotiate better terms during transactions.
Avoids costly mistakes
Accurate pricing models can safeguard investors from making costly mistakes, such as over or under-valuing a property.
Matches the Investor’s Goals
The value of a property is highly dependent on the specific purpose of the investor for purchasing the property. Valuation modeling becomes even more essential when we examine its significance from an individual investor’s perspective.
For instance, some investors may focus on acquiring properties with high appreciation potential, anticipating the property’s value to increase over time. Others may emphasize cash flow generation through rental income, prioritizing properties with consistently high and stable occupancy rates.
Assess the Risks Involved in the Investment
Valuation modeling allows investors to assess the level of risk involved in their investments. Factors such as neighborhood characteristics, market trends, and economic indicators are considered when determining a property’s value.
This helps investors gain a comprehensive understanding of their potential investment and equips them with valuable insights into the market dynamics and potential risks.
Three Property Valuation Methods
Property valuation modeling combines three traditional approaches—sales comparison, cost, and income—to provide a well-rounded, accurate estimate of a property’s value.
This valuation technique determines the value of a property by considering both the land it sits on and the cost of constructing a similar new building.
This method combines real commodity values, such as construction materials and labor costs, with the market value of the comparable land. It is beneficial when evaluating infrequently sold properties that don’t generate income, like schools, hospitals, or government buildings.
In the case of a pre-existing property, the appraiser must not only estimate the current cost of replacing the structure but also account for any depreciation factors such as:
- Physical deterioration such as painting, roof replacement, plumbing
- Functional or structural obsolescence like obsolete design, outdated technology, and equipment
- External obsolescence, such as the changing neighborhood, competition, new zoning regulations
- Economic degeneration, such as inflation, interest rate changes, and recession
To ensure a thorough evaluation, appraisers often use reliable sources of construction cost data. Several techniques estimate building costs, such as the square-foot, unit-in-place, and quantity-survey methods.
- Square-foot method: Calculates the property valuation by multiplying the cost per square foot of a similar, recently built property by the total square footage of the subject building.
- Unit-in-place method: Estimates the cost of replacing the individual building components, such as walls, floors, roofs, and heating systems, on a per-unit basis. The valuation considers the cost of labor and materials for each unit.
- Quantity survey method: Estimates the total cost of replacing the subject building by breaking it down into its constituent raw materials, such as concrete, bricks, and steel. The valuation process considers the current prices of these materials and the associated installation costs.
Valuation using the cost approach should also consider local market trends and industry standards to develop accurate estimates.
Sales Comparison Approach
The sales comparison or market approach valuation analysis looks into the value of 3-5 similar properties—called comparables, or “comps”—sold within the same year in the same geographical area. Real estate professionals and appraisers examine property size, location, building quality, and amenities to determine a property’s worth relative to the comps.
This approach is typically used for residential properties and if the investor is applying for conventional financing.
The income or capitalization approach is particularly relevant for income-producing properties like rental apartments or commercial buildings.
This approach considers crucial factors such as gross expected income, vacancy and collection loss, effective gross income, operating expenses, and net operating income. This makes the Income approach the most data-heavy yet more accurate method for getting the valuation of a property.
The two main ways to use the Income Approach are:
- Direct Capitalization from a single year of income
- Discounted Cash Flow (DCF model) using a multiple-year projection period and reversionary value
Here’s the step-by-step of Income Approach:
- Calculate the NOI
- Compute the cap rate
- Divide the NOI by the cap rate to estimate the property value
Elevate Your CRE Investment Decisions With Blooma
Commercial real estate valuation is an intricate and essential process, full of moving parts and metrics to consider.
Navigating this complex landscape can be remarkably simpler with the help of an innovative platform like Blooma. By leveraging its advanced technology, Blooma streamlines the valuation process by tapping into and aggregating thousands of data points from multiple sources. The result is the most accurate picture of property valuation that informs your investment decisions and gives you more confidence going forward.
Blooma’s platform creates a proforma income valuation on your behalf by pulling market data to determine factors like revenue, expenses, NOI, and cap rate. The best part is that it is completely editable, so you can customize as you see fit.
If you’ve got a model you’re already using, Blooma can map all the proforma data to your existing template and Excel spreadsheet—no lift required.
When you’re equipped with comprehensive, reliable information backed by AI-powered technology, the possibilities for financial analysis and your portfolio growth rate are limitless.
Elevate your property investment decisions to new heights with Blooma. Schedule a demo today.