Commercial Real Estate Valuation | GRM, Cap Rate, and DCF
There are a variety of commercial real estate valuation methods that help estimate the value of income properties. These valuation methods include the capitalization rate (cap rate), gross rent multiplier (grm), and discounted cash flow analysis.
Investment property valuation methods all use the financial performance of the subject property to estimate the investment value. These methods are used in conjunction with other indicators of value such as cost per unit, per square foot, replacement cost and other factors to evaluate and estimate investment property value.
Commercial Real Estate Valuation Methods
Gross Rent Multiplier
The Gross Rent Multiplier, or GRM, is a number that is multiplied by the Scheduled Gross Income from the Pro Forma Cash Flow Statement to arrive at an indication of value. The GRM is determined by comparing the multiplier used in comparable properties in a similar market to arrive at a market value. It is also similar to the cap rate in that it is a shortcut, it uses a single period, and it uses a ratio to calculate a market value.
Property Value = Scheduled Gross Income x Gross Rent Multiplier
The Capitalization Rate
Capitalization is the process of converting an investment property's Net Operating Income into an estimate of market value by using a percentage rate. The rate used is known as the Capitalization Rate or Cap Rate. The value of the property is determined by dividing the property's Net Operating Income from the Pro Forma Cash Flow Statement by this percentage number. In other words, the Net Operating Income is equivalent to a percentage of the estimated Market Value of the property.
Property Value =
Net Operating Income
Capitalization Rate
or
Net Operating Income = Capitalization Rate x Property Value
The appropriate cap rate is estimated by analyzing the Net Operating Income and sales prices of comparable properties in the same market. It uses a single period NOI and is a shortcut way to indicate the value of an investment property.
Discounted Cash Flow Analysis
The Discounted Cash Flow Analysis is a multi-period approach that incorporates the Time Value of Money to discount the estimated future cash flows of an investment property to determine its Present Value. The periodic future cash flows are estimated by creating a Pro Forma Cash Flow Statement for each future Period. This includes the Operating Cash Flows for each period, as well as the Reversion Cash Flows at the end of the holding period.
The cash flows of each period are discounted by determining their Present Value by applying an appropriate discount rate to the cash flows of each Pro Forma Cash Flow statement. In addition to being able to forecast the vacancy rate and rents, one must also be able to determine the discount rate used in the Discounted Cash Flow Analysis. Therefore, this approach is more complex then the single period estimations provided by the Gross Rent Multiplier or the Cap Rate approaches.
Value = CF1/(1 r^n) CF2/(1 r^n)^2.... CF (t - 1)/(1 r^n )^t - 1 CF (t) / (1 r ^ n) ^ t