Calculating the value of commercial real estate is a key factor in determining whether a particular investment is a smart one or not. Value is not necessarily conveyed accurately by means of asking price or selling price. Rather, investors should take the time to fully assess a particular property’s value to them before deciding to proceed with a purchase.

Value can be estimated in many ways, but for income-generating properties that are more likely to be bought and sold, the income method of valuation is likely to be the best fit. The income method involves scrutinizing the anticipated net operating income of a property, along with an investor’s desired capitalization rate on that property, in order to arrive at a value specific to the priorities of that investor.

The first step is to estimate the annual net operating income of the commercial real estate property under consideration. Look at the annual gross income that you could collect if all available space for rent was fully occupied over the entire year, and all tenants paid their rent in full and on time. Then estimate the operating expenses associated with the property. These can include property management fees, maintenance and repairs, and possibly even renovations to the property. You should also build in some estimates for vacancies, non-payment of rent and advertising for new tenants. Subtract the annual operating expenses from the annual gross income to find the annual net operating income.

Next, consider the capitalization rate, or rate of return, that you would like to achieve with this commercial real estate investment. What is your desired rate of return? What is the minimum rate of return you will accept? Divide the annual net operating income first by your desired rate of return, then by your minimum acceptable rate of return. These results are the value of the property to you, based on those rates of return.

Compare these results to the asking price. If your desired rate of return yields a property value that is higher than the asking price, congratulations! This property could be undervalued and a great investment for you. On the other hand, if your minimum rate of return yields a property value that is lower than the asking price, this property may be overvalued and probably not worth your investment.

Commercial real estate valuation takes time and effort, but the forethought can be worthwhile if you are able to sort the potentially good investments from the bad.