How Commercial Property Is Actually Valued
Three approaches, one of which does most of the work in New York.
Commercial valuation uses three recognized approaches. Understanding which one drives a given valuation explains why two credible professionals can reach different numbers for the same building.
The income approach
For income-producing property this does most of the work. Net operating income — rental income less operating expenses, before financing and tax — is divided by a capitalization rate to produce a value.
The capitalization rate reflects what buyers currently require for that kind of asset in that location. Because value is income divided by that rate, small changes in it move valuations substantially. This is the arithmetic behind large swings in commercial values when interest rates move, with no change in the buildings themselves.
The sales comparison approach
Comparing recent transactions of similar properties, adjusted for differences. It works well where transactions are frequent and comparable, and poorly for unusual assets or in thin markets — which is precisely when valuations are most contested.
The cost approach
What it would cost to build the equivalent today, less depreciation, plus land value. Used mainly for new, special-purpose or unusual buildings.
What actually moves the number
Lease terms dominate. The same square footage produces different values depending on lease length, tenant credit quality, escalation provisions and how expenses are allocated between landlord and tenant.
A building let to strong tenants on long leases with fixed escalations is a different asset from one with short leases to weaker tenants, whatever the two look like from the street.
Vacancy and the assumptions beneath it
Valuations assume a stabilised vacancy rate and a cost to re-let. Where market conditions change, those assumptions change, and disagreement about them explains much of the disagreement about values.
Reading a valuation
Go to the assumptions rather than the conclusion: the capitalization rate, the vacancy assumption, the projected rents on renewal, and the allowance for capital expenditure. That is where the judgement is.