Real Estate Valuation in Business Plan Preparation

One thing that strikes me about the three methods of valuation they describe here is the greater presence of soft factors compared to the classical valuation techniques (like CAPM) for other assets (stocks, companies, bonds) as taught in MBA programs. It leads me to think that real estate values as we know them today are inexact in a way that makes me a little uncomfortable, but also, I suppose, reflect the human element inherent in real estate and its use.

I once had this disastrous temp job in the office of a mortgage broker. For every loan we did we had to print out a 20 page stack of disclosures mandated by the State and Federal Governments that had mostly to do with discrimination and financial shenanigans. It taught me that residential real estate was in the not so distant past a rather dirty business and so they were slapped with a lot of onerous government regulation in about the '70s. The paperwork was a nightmare. This is what happens to industries that behave badly. I have to admit that the relative lack of regulation is what drew me to commercial real estate.

In any event, the consideration of "soft" factors like the type of tenants and level of landlord involvement into cap rates, IF cap rates like this are used in residential real estate, could be the financial underpinnings of housing discrimination in the past, when people moved out of neighborhoods as minorities moved in for fear for their real estate values. That being said, it seems to me at first glance to be inexact. We (in Project REAP) haven't learned about cap rates yet (though I have an idea as to how to calculate it from my own readings), but it would be interesting how the cap rate formula takes into account other tenants and landlord involvement.

With this being said, I would lean towards the cost approach to valuation. I am sure all three methods have their merits and I wonder if different valuation techniques are used for different types of properties or transactions. I suppose I will find this out later when we get to the unit on finance.
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Real Estate Valuation in Business Plan Preparation

By Gary N. Chabot

Two of the major cash flow components of small business operations are the start-up capital requirements for commercial real estate and the ongoing expense of renting and operating the space which the business is located.

Whether a company leases space or invests in its own land and building, the value for the real estate is of concern to several parties. These parties include potential lenders, other partners or shareholders, the small business owners themselves and the landlords who rent space to the business. Part one of this series deals with some of the ownership value considerations of real estate, while the second part will explore some of the important areas of leasing the business location.

Ownership value considerations

Beyond the "common sense" criteria of investing in real estate for the business (price and value, location, size and utility), the business owner also must consider that determining real estate value is important when preparing business plans for financing purposes.

Regardless of how valuable the location may be perceived by a business owner, the amount of the real estate financing is directly linked to the property's appraised value from an independent third party's point of view. Typically, a conventional lender will lend up to approximately 75 to 80 percent of the appraised value of the property. This means that the business owner must have the financial capability to finance the remaining 20 to 25 percent plus the required closing costs and other out of pocket expenses involved in financing the transaction.

In preparing business plans and required cash flow projections, many small businesses fail to consider the additional working capital required for financing or buying commercial real estate.

In addition to good faith deposits and down payments, these additional costs may include bank fees and points (one point equals 1 percent of the loan amount), legal fees, appraisal costs, environmental studies, additional fit-up or construction costs, brokerage fees and deed transfer taxes and recording fees.

Determining Value

Appraisers consider real estate value from three points of view and determine an estimated of value based upon weighing the three valuation methods. These three methods are comparable sales method, income approach, and cost approach.

Quite simply, the comparable sales method determines an approx. value based upon sales of similar properties within a reasonable recent period of time. Similarities include type of property, age, location, size and other tangible criteria. Value adjustments are made (either positive or negative) for the subject property relative to the sold property. For example, if a sold property was in better condition, or newer, than the subject property, then the adjustment would be made to lower the sold property's actual value to make it more comparable to the property being appraised.

The income approach determines an estimate of total real estate value based upon the rate of return from potential net operating income from the property (assuming it was leased to a third party). In this method, an appraiser would estimate an annual income rate for the property based upon similar rated for similar users. For example, the appraiser might determine that a retail store might rent for a rate of $9 per square foot per year. This rate should be comparable to other retail spaces in the vicinity (which should be documented in the appraisal document).

Once this lease rate is determined, the property's value is estimated using a type if multiplier known as a capitalization rate, or cap rate. Historically, cap rates are subject to several factors including the strength of the type of tenant, the level of landlord involvement, economic conditions and type of industry. However, for illustrative purposes, a property with a good tenant in a good location might command a cap rate of 12 percent in a good market.

The value of the real estate is determines by multiplying the net rental rate by the reciprocal of the cap rate. In the example given, the value would be calculated by multiplying $9 per square foot by 8.3 (100 percent divided by a 12 percent cap rate). This would mean that the investment value of the real estate would be equal to $74.40 per square foot.

Often, these figures are further adjusted to consider other variables such as vacancy rates, property management costs and other investor related factors.

The cost approach evaluates the replacement value of the property by analyzing the cost component of the specific land and building. The variables involved in estimating value are contingent upon location, geographic region of the country, labor and material costs.

Factors that are considered include costs for land acquisitions, site preparation, utilities, types of building materials, tenant improvements and soft costs (architectural and engineering costs, legal and brokerage fees and other similar related costs).


Reconciliation of the three methods

All methods are then summarized, reconciled and compared to each other to evaluate their relative values.

In a perfect business environment, the three variations of value would likely produce relatively similar results. Quite often, however, each method may produce somewhat different values from one another. This occurs because all real estate is unique, general economic conditions may vary by region and time and good market information is not readily available to buyers, sellers, landlords and tenants in the real estate market (as compared to stock markets).

Because of these general principles, the valuation of commercial real estate is an educated estimate based upon several factors. These include the collective experience and expertise of the appraiser, available and relevant information in the market, the willingness of the lender to accept the estimates and the ultimate agreement of the buyer and the seller on the property's price and terms in an independent, arm's length transaction.

© 2002 NHSBDC
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