Valuation of Residential vs Commercial Real Estate

Residential and commercial properties differ in their application, and the methods used for calculating their values are also quite dissimilar. Residential real estate’s value largely depends on the location, physical, and socioeconomic characteristics of the land. Urban development and infrastructure also influence the value of a residential property. However, in the commercial landscape, value is derived from the income a property generates. A variety of appraisal methods are used to calculate the current rate of income against the property cost, future revenue forecasts, and risk assessments to ensure that a commercial property is worth the investment. Continue reading to gain a better understanding of the valuation methods used in appraisals of residential and commercial real estate.

It is necessary to conduct a property valuation while planning to invest in real estate. Investors have the option to choose between residential and commercial properties, however, the valuation methods for each differ in their approach. Residential real estate is mostly appraised using the comparison approach where properties having similar physical characteristics are compared along with other socioeconomic attributes to arrive at a fair market value (Pinkasovitch, 2021). On the other hand, a commercial property can be appraised using several methods. The sales comparison method, gross rent multiplier method, cost approach method, and income capitalisation approach are mostly used in the valuation of commercial properties (Cauble, 2020). It is particularly important to calculate the capitalisation rate as the value of a commercial property depends on the level of income it generates (Chen, 2020). Therefore, an investor must keep in mind the different methods and the impact of those methods on future profit forecasting before investing in residential or commercial property. 

Residential real estate is defined as single-family homes, apartments, condos, townhouses, and any building that has less than four units (Santarelli, 2021). The demand for residential real estate stems from the fact that it is considered a safer investment, having easier laws and regulations for its sale and purchase. The predominant method of calculating value in the residential real estate market is the comparison method. Comparables having similar physical and socioeconomic characteristics are analysed to reach a fair market value. There are many parameters that can be set according to different requirements such as comparing properties sold only in the last month or under certain market conditions. The second method for finding value is called the cost approach. In this method, the cost of purchasing a similar piece of land and the construction cost is added up to attain a fair market value. This method is famous for properties that are newly constructed. Therefore, carrying out the valuation of residential properties is considerably straightforward. Many companies in the developed world have online mechanisms with databases that can generate an estimate for a property’s value in a few seconds. However, Pakistan’s real estate sector lacks such services. But not all hope is lost. Companies like Graana.com, Pakistan’s smartest property portal, are changing Pakistan’s real estate landscape by introducing artificial intelligence systems that can evaluate a property based on multiple factors. With the successful implementation of such systems, it is hoped that Pakistan’s real estate sector will have increased transparency and security.

Commercial real estate is largely valued based on the level of income a property generates. Aspects like existing leases, rental rates for comparable properties, property square footage, property type, and macroeconomic conditions are used to calculate the expected income. The operating expenses are calculated by assessing factors like the property’s historical operating expenses, maximum allowable depreciation, known operating expenses for similar categories, and best practices for each expense category. After acquiring the income and expenses of a property, calculating the capitalisation rate is the most important step. The cap rate is used to estimate the rate of return that is expected to be generated on a real estate investment. It must be noted that the value of a property is not the same as its cost. The value is obtained by dividing the net operating income by the property’s asset value. The cap rate is a fairly accurate way to calculate the return on investment. Although the capitalisation rate can be useful for comparing the relative value for comparable properties, it does not factor in the time value of money, leverage, and future cash flows of the property. There are also no decided good or bad ranges for a cap rate and the investor is left to decide on his personal discretion.

Real estate valuation methods suggest that two or more comparable properties should be similarly priced according to their earnings. Price to earnings ratios and price to sales ratios are important indicators used to determine the comparison. Commercial real estate valuations must also keep future cash inflows in consideration. Methods like the dividend discount model (DDM) and discounted cash flow (DCF) are often used for forecasting future revenues. Lastly, the Gross Income Multiplier approach is also used in the valuation of commercial real estate. The method assumes that properties in the same location will have similar incomes. Gross income is the total income generated before deducting any expenses, however, the vacancy rates have to be forecasted to obtain a proper gross income rate. The next step is to calculate the gross income multiplier, which can be obtained from historical data. Although the method is similar to the comparison approach in the residential sector, analysts use this method to forecast the earnings of a property (Reonomy, 2020).

Buying, selling, and investing in real estate requires accurate property valuations. Many people assume that residential and commercial real estate is valued in the same way. However, there are key differences involved in the appraisal method. Residential properties are valued for their location, physical, and socioeconomic characteristics, whereas commercial real estate is valued based on the level of income generated over time. Understanding these differences can help an investor in deciding the best possible investment strategy over time.

Cauble, T. (2020). How Is Commercial Real Estate Valued? Here’s The Answer. Retrieved from https://www.tylercauble.com/blog/how-commercial-real-estate-is-valued

Chen, J. (2020). Capitalization Rate. Retrieved from https://www.investopedia.com/terms/c/capitalizationrate.asp

Pinkasovitch, A. (2021). How to Value Real Estate Investment Property. Retrieved from https://www.investopedia.com/articles/mortgages-real-estate/11/valuing-real-estate.asp

Reonomy. (2020). A Look at the Best Commercial Real Estate Valuation Approaches. Retrieved from https://www.reonomy.com/blog/post/commercial-real-estate-valuation

Santarelli, M. (2021). Commercial vs Residential Real Estate Investing: Which is Better? Retrieved from https://www.noradarealestate.com/blog/residential-vs-commercial-real-estate/