How Property Values Are Determined: Residential vs. Commercial


Property values by themselves are important for your bottom line. The value of a property is directly tied to the overall profitability of that investment.

But are property values only useful when it comes time to figure out how much money is going to end up in your pocket? No!

The more you understand property values, the more intelligent you can be about what properties you invest in, and the more creative you can be in finding ways to increase the value of a property so you can ultimately see more profit in your pocket.

The key thing to learn about property values is how they’re determined in the first place. Sounds boring on the surface, but it gets a lot more exciting when you learn how to incorporate those methods of valuation into your profit potential.

How a property is valued differs between residential and commercial properties. This means that whether you’re investing in residential or commercial properties will dictate how you can know what you should be paying for a property, as well as the ways you can increase the value of that property.

Understanding residential versus commercial properties

Let’s make sure you’re clear on what properties are considered residential and which ones are considered commercial.

  • A residential property is made up solely of residential units (ones people live in). The residential classification pertains to properties containing 1-4 units. So these may be single-family homes, duplexes, triplexes, or fourplexes. A fourplex is the highest number of units a property in the residential classification can have.
  • A commercial property is any building used for business purposes. Shopping centers, self-storage facilities, warehouses… all of those are commercial buildings because they’re used for business. Where it gets a little tricky is when we start talking about residential units within a commercial building. An apartment complex, for example, is considered a commercial building, even though tenants are living in the units rather than working in them. These types of buildings are considered multi-family properties. While the residential classification includes 1-4 unit properties, any multi-family property that is 5+ is considered to be a commercial building, despite the residential occupants.

Why this distinction matters is because how the value of a residential versus a commercial property is determined is completely different.  

How the value of residential vs. commercial properties is determined

  • The value of a residential property is dependent on the market. While “market” gets used in a lot of different contexts in real estate investing, in this case it’s referring to the general real estate market… the real estate industry. Are prices generally high or low at a particular time? The market as a whole dictates much of a property’s value. The term you’ll hear on a regular basis for residential valuing is “market value”. The market value of a property is most generally just what it would sell for under normal conditions. If someone came to look at your house and wanted to buy it, what would be a valid price that they should pay?
  • The value of a commercial property is dependent on the income it brings in. While residential properties are valued solely based on current market value, commercial property values are solely based on the income the property generates.

Market value for a residential property is ambiguous compared to the valuation of commercial properties based on their income. When you know the income on a property and what percentage of the purchase price investors expect the income to be, it’s pretty straightforward to determine the value of the property. With residential properties though, it’s more about what other like-kind properties are selling for nearby the property you’re trying to value. Not at all as straightforward.

The most important term you need to understand when analyzing commercial real estate deals is capitalization (“cap”) rate, which is measurement of the relationship between the value of a property and the income it brings in. Since the entire valuation is based on that relationship, there’s no way to value or analyze commercial properties without understanding. I don’t want to distract from the point of this article to explain how cap rates work, but if you aren’t familiar with them, check out Commercial Real Estate Net Operating Income (NOI) and Cap Rate.

Now, how to use this knowledge of how residential versus commercial properties are valued.

There are two primary times when you need to understand the bases for these valuations:

  • Evaluating prospective properties to invest in. If you don’t know how properties are priced, you can’t know if you’re getting a good deal for a property or not. How do you know if you’re overpaying? And more generally, understanding how properties are valued will greatly aid in your ability to negotiate deals (while sounding like a professional investor instead of an ignorant newb).
  • Finding ways to increase the property value. One of the most exciting things about real estate is our ability to more directly control the fate of our investment than we could if we invested in stocks or something that we can’t make changes to in order to increase our profit returns.

Evaluating prospective properties to invest in

You have to be able to know if you’re getting a good deal on a property before you buy it. In order to do that, you have to know how something’s priced, i.e. how it’s valued.

One of the dumbest things I hear new investors say (sorry if you’ve said this, but you have to learn some time!) is when they’re analyzing a prospective rental property for sale and they say it’s overpriced because the cash flow on it isn’t as high as it should be. Well guess what, rent returns don’t dictate the price of residential properties, and the reality is that a huge number of properties are in areas that notoriously don’t cash flow.

I’ve heard several times someone say there’s a rental property for sale in California (worst cash flow in the nation) and because the listed price of the property doesn’t give way to any cash flow, they’re going to offer the seller a number that would allow it to cash flow.

Okay, please don’t do that. You’re going to sound so amateurish it’ll be painful.

The reason that idea doesn’t work is because, again, residential property prices could care less about the income. If they don’t cash flow, that’s your problem, not the seller or the market’s.

When you shop for residential properties, you need to be familiar with the current market values to know whether you’re getting a good deal on a property or not (regardless of income). When you shop for commercial properties, you’re comparing the income generated by the property to the price of the property, and that’s how you can tell if you’re getting a good deal or not.

Finding ways to increase the property value

Even more fun, and creative, than making sure you buy smart is to look for ways to increase the value of any property you invest in.

The first thing to remember is how values are determined, and then you can know how to increase that value (i.e. what factors contribute to the value that you can increase?).

  • Residential property

A unique thing about increasing the value in residential properties is that, while you can do it, there is a cap to how much you can improve something because eventually you’ll cap out at whatever the market allows for pricing. For example, if you buy a house on a rough street full of cheap, nasty houses, and you make that house the nicest you can—granite countertops, LVP flooring, wonderful landscaping, all new appliances… the market value of that house can only go so high because of where it’s located. Eventually you’ll hit a point in improving where all you’re doing is spending more money without the ability to generate a higher market value any longer. So be careful of this!

But assuming you aren’t maxing out the improvements on a property past market value level, here are ways you can increase the value of a residential property:

  • Improve the condition of the property
  • Buy in an appreciating market (or wait for the market to appreciate) so the market itself increases the value of your property
  • Commercial property

Since the only thing that dictates the value of a commercial property is the income generated by that property, the one way to increase the property value then is to increase the income on the property. Maybe you rehab all of the apartments in a multi-family building so you can charge more in rent, or you fill a significant number of vacancies (self-storage, retail shops, etc.). When you increase the income, the property value increases.

There’s obviously a lot more discussion that could be had about changing property values and how best to utilize the ability to do so in ways that will maximize your investment returns, but hopefully this gets you thinking down the basic lines of how properties are valued or priced, so you can better gauge the quality of any deals you’re analyzing. And then investors always want to increase their property values, so now you know which ways to look if you want to do that to your property.

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