This paper examines the factors that cause commercial property market values to fluctuate over time, with particular focus on the period surrounding the late-2000s recession. It introduces the three primary appraisal methodologies — the cost approach, the sales comparison approach, and the income approach — and demonstrates how the income approach is used to calculate estimated market value through net operating income and capitalization rates. The paper also discusses how operational costs, vacancy rates, borrowing costs, and broader economic conditions influence property values. Finally, it explores the role of proactive and integrated property management as a risk-mitigation strategy for protecting real estate assets.
Commercial property is a term used to refer to properties occupied by firms in order to do business — including office buildings, warehouses, factories, distribution centers, stores, logistics centers, restaurants, shopping centers, food outlets, bowling alleys, cinemas, and other types of entertainment facilities. This category also includes research and development (R&D) facilities (Property-Investing, 2010). The Complete Real Estate Encyclopedia defines commercial real estate as "typically office or retail space, or multifamily residential properties such as apartments."
The commercial property market had been facing its worst years since its crash in the early 1990s, according to forecasters such as CB Richard Ellis, one of the largest property consultants in the world (Times, 2007). Returns in this property segment were predicted to plunge to almost zero by the end of 2007, down from 18.1% the previous year. This followed a steep correction in the commercial property market that had already wiped out close to £14 billion from the £350 billion investment market between July and October 2007 (Times, 2007).
Several factors can contribute to the movement of commercial property market values over time. Various methodologies exist for calculating market value, and the basic components of any such calculation are relatively familiar — addressing market conditions and income generation (Forsyth, 2010).
Existing appraisals typically value real estate assets using three distinct methodologies.
This approach estimates the cost required to build a new building identical to the one being appraised at current market prices, subtracting accumulated depreciation and adding the estimated value of the land on which the subject is built (BC, 2011). In other words, it estimates the replacement value of a given property. Pratt, Reilly, and Schweihs (1998) note that adjustments are then made to the fee simple value indicated for the property in order to reflect the property interest being appraised. A noted controversy surrounding this methodology is that it does not indicate fee simple market value (Jones, 2005).
This approach provides a comparison of sales prices for comparable assets within the same property market. O'Connor (2010) describes the sales comparison approach as one of the most intuitive and best-understood of the three main appraisal techniques. Its primary users include companies renting office space, home buyers, and real estate investors.
The process of performing a sales comparison includes selecting sales comparables and making appropriate market adjustments. Selecting comparables is a demanding task, as there are often minor nuances that are not immediately obvious; accurately making these adjustments therefore requires considerable research, experience, and skill. The selection of comparable sales is the most critical aspect of this approach — the comparable sales values must be sufficiently similar to the subject property to produce a meaningful value indication. Appraisers typically focus on property type (land use), location, date of sale, and size when selecting comparable sales, weighing which features are most meaningful in a given case. Because the real estate market is never fully fungible and sales levels fluctuate periodically, comparables are never identical to the property being appraised.
The income approach provides a projection of the property's cash flow. It is the most preferred approach for evaluating commercial real estate when reliable property rent and operating expense data are readily available. Sales data is also required for the development of income multipliers and overall capitalization rates (SAMA, 2001).
Although all three approaches are considered in calculating the market value of a given commercial property, the most emphasized approach for an income-producing property is the income approach. This is because cash flow analysis provides the basis for an expected investment return or income stream for a given property.
Market value using the income approach is calculated by dividing Net Operating Income (NOI) by the Capitalization Rate (Cap Rate):
Estimated Market Value = Net Operating Income / Capitalization Rate (Forsyth, 2010)
Net income may take several forms, but is generally calculated as the annual gross income of the property less annual operating costs. Cap rates are derived from investment return assumptions or the cost of borrowing and vary by property type, location, and overall risk in the property market. An appraiser or investor calculating market value will generally refer to cap rates used for the most recent comparable assets in the same location as the subject property.
Consider a commercial property with an annual net operating income of $5,000,000, where a comparable sales property in the same region carries a cap rate of 7%:
$5,000,000 / 7% = $71.4 million
The market value for the commercial property is estimated at $71.4 million.
If the annual vacancy rate increases and net operating income decreases to $4,000,000, with all other factors held constant:
$4,000,000 / 7% = $57.1 million
The market value for the commercial property would then be estimated at $57.1 million. This illustrates how even a moderate decline in occupancy can significantly reduce a property's estimated market value.
"Identifies operational and market drivers of value change"
"Examines recession's impact on European and U.S. markets"
"Describes integrated risk management strategies for property"
The market value of commercial property has fluctuated considerably over time. The period surrounding the late-2000s recession saw particularly heavy losses, driven by declining occupancy rates, falling rents, and tightening credit conditions. There are indications that the real estate market has recovered substantially in some locations — for instance, the office market in Oklahoma City was reported to have put the recession behind it (Mize, 2010). Going forward, there is a clear need to develop robust appraisal tools and incorporate them within an elaborated proactive property management framework to better protect and optimize commercial real estate assets.
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