Commercial Real Estate Valuation Explained

Unlike residential real estate (which is usually just priced based on comparable sales in the area), commercial property prices have a lot more moving pieces.

The income an investor can expect to generate, what an investor believes they can sell a property for in the future, and even the way a property is financed can all impact commercial real estate values.

So in this post, we’ll walk through the process used by investors to come up with offer prices on commercial real estate deals, and how the biggest firms in this industry determine what they’re willing to pay for a property.

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Target Returns

When commercial real estate firms analyze a potential investment, they’re looking to generate a return on their capital, and this is usually the biggest driver of what they believe a property is worth.

And because of that, most real estate investment firms will use a target return figure to come up with a valuation of a deal, typically based on the IRR, the equity multiple, and/or the cash-on-cash return.

To come up with a valuation based on these return metrics, the first thing an investor will do is go through the process of making financing, operating, and sale assumptions on a deal. And from there, they’ll back-solve for an offer price that would get them to their return targets.

The IRR tends to be the most common return metric that’s used to value commercial properties (especially among larger institutions), because this measures the annualized, time-weighted return on capital invested.

The time-weighted aspect of this figure tends to be extremely important, especially for pension funds or insurance companies that need to make regular or one-time payments at very specific time intervals.

Many of the biggest real estate investment firms in the world also raise capital from equity partners using IRR-based performance hurdles, which are then used to calculate promoted interest to the general partner on a deal.

For the equity multiple and cash-on-cash metrics, these are used a lot less frequently as the primary driver of a property’s valuation, but these both have very specific use cases for certain investment firms.

In my experience, the equity multiple is often used as a benchmark for companies with an investor base made up primarily of high-net-worth individuals or family offices with extremely long investment horizons, where the timing of distributions isn’t a huge concern.

And for the cash-on-cash metric, this is often the main benchmark used for investors trying to generate a predictable monthly or quarterly income, which can sometimes be the case for publicly traded REITs or individual investors that are looking to replace a paycheck.

Regardless of the target return metric investors choose to use, the next step in this process is to create cash flow projections for the deal being analyzed, to find the purchase price of the property that would result in the investor hitting their target returns.

For example, let’s say a property is assumed to generate $100,000 per year over the next 10 years, and the projected sale price of that property is $20 million at the end of that 10-year period. In this case, if the investor needs to generate a 2.0x equity multiple on their initial investment, the maximum purchase price the investor could offer would be $10.5 million.

This is also why different investment firms often come up with very different valuations for the same property, even with the same cash flow projections. An investor that needs to generate a 14% IRR will need to pay less than an investor who only needs to generate a 12% IRR, all else being equal.

Replacement Cost

On top of just using target return metrics to value a property, commercial real estate investors will also usually look at another metric to determine if that target return valuation makes sense, and this is the property’s replacement cost.

Replacement cost refers to the total cost for an investor to buy land in the immediate area and build a virtually identical building to the property being analyzed, including similar features, amenities, and finishes for tenants.

For this metric, most investors will want to see that they’re buying a property at a price below today’s replacement cost, and also that they’re projecting to sell that same property below what they believe replacement cost will be when they’re ready to exit the investment.

If the purchase price of a property is above replacement cost, this indicates that it’s actually cheaper to build new product than to buy an existing, operational asset, which is typically a sign that a large number of developers will soon enter the market and drive up new supply.

However, if the purchase price of a property is below replacement cost, this means that it’s more expensive to build new product than to buy existing real estate, which makes it less likely that developers will find the market attractive.

If development activity is low in a market, this usually leads to higher occupancy levels and higher rent growth long-term. So while this metric doesn’t directly tell an investor exactly what their maximum offer price should be, this can do a lot to help validate (or invalidate) a target return metric valuation.

Comparable Sales

On top of the two methods we just talked about, there’s one more thing that’s often used by investors to value commercial properties, and this is a comparable sales analysis.

A comparable sales analysis involves an investor analyzing the price per unit or price per square foot of a property in relation to other recently closed transactions, to see how their projected offer price stacks up against other sales in the market.

For a property to be considered comparable, it needs to be the same type of property as the deal being analyzed, ideally with a similar year of construction, similar amenities, and similar location.

This analysis tends to be the most helpful on deals that are located in active real estate markets with multiple recent transactions in the immediate area, and this is even more helpful when analyzing off-market deals with a very small number of bidders.

In most cases, investment firms will look for deals they can buy at a price point that’s either in line with or below the average of comparable sale prices. This helps them build in a margin of safety in case they need to sell quickly, and also allows them to point to a discount to market value when raising capital from equity partners.

How These Work Together

During the investment analysis process, all three of these metrics are typically used at the same time, with a target return metric valuation being used first and foremost, and replacement cost and comparable sales analyses being used to test that valuation.

If an investor can hit their target returns at a price point that’s below replacement cost and in line with or below recent comparable sales, this is usually a green light for investors to move ahead with an offer.

But if a target return metric valuation results in a price point that’s at or above replacement cost, or significantly above recent comparable sales, this is usually considered a major red flag in the underwriting process that can indicate a lot of new supply risk or something else an investor is missing.

How To Learn More About Real Estate Investment Analysis

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