Value is traditionally defined as the power of a good to command other goods or services when exchanged. Within this broad definition of value, there are various types of value given to real property, such as investment value, market value, insurable value, assessed value, liquidation value, or replacement value. In this article, we’ll go over different types of real estate value, and then zero in and focus on the difference between investment value and market value.
Types of Real Estate Value
First of all, let’s briefly go over several common types of commercial real estate value, then we’ll dive into the difference between investment and market value and clarify with an example.
Market Value is what’s typically meant when referring to a property’s value and is the value used for loan underwriting purposes. The Appraisal Foundation has a specific definition for market value as published in the Uniform Standards of Professional Appraisal Practice (USPAP). According to the Appraisal Foundation, market value is the most probable price a property would bring in a competitive and open market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimuli.
Investment Value refers to the value to a specific investor, based on that investor’s requirements, tax rate, and financing.
Insurable Value – This covers the value of the portions of a property that are destructible for the purposes of determining insurance coverage.
Assessed Value – Assessed value is the value determined by the local tax assessor to levy real estate taxes.
Liquidation Value – Liquidation value establishes the likely price that a property would sell for during a forced sale, such as a foreclosure or tax sale. Liquidation value is used when there is a limited window for market exposure or when there are other restrictive sale conditions.
Replacement Value – This is the cost to replace the structure with a substitute structure that is identical or that has the same utility as the original property.
A property can have any of the above types of value at any given time, with no two values necessarily being the same. This is an important point to remember when trying to understand the value of a commercial real estate property. This is especially true when determining market value and investment value.
Key Differences Between Market and Investment Value
- Market Value: Represents the most probable price a typical buyer would pay under standard market conditions. Appraisers rely on standardized assumptions—average rents, typical expenses, occupancy rates, and prevailing cap rates and discount rates—to estimate value, typically using sales comparisons, cost approach, or income capitalization methods. Market value calculations exclude specific financing or personal factors.
- Investment Value: Reflects what a specific investor would pay, considering their personal financial goals, unique operational strategy, and individual financing terms. Investors often use cash-on-cash returns, equity multiples, comparable sales, direct capitalization, or a levered DCF analysis focused on equity IRR to determine this personalized value.
Approaches to Market Value
Market value is what’s determined by an appraisal. During the commercial loan underwriting process, lenders will require a third-party appraisal to determine a market value estimate, which is then used to find an appropriate loan amount and collateral value.
How do appraisers determine market value? First, before a market value can be estimated by an appraiser, the highest and best use for the property must be determined. The highest and best use is the legally permissible use of a property that is physically possible and also that yields the highest present value. This process usually begins with evaluating the zoning laws to understand the legally permitted uses for the property.
Once the legally permitted uses are understood, the physically possible uses are then considered, within the bounds of the zoning ordinances. This takes into account the physical limitations of the property such as topography, size, layout, etc.
Finally, a basic financial feasibility is considered for all the uses that are legally permissible and physically possible. The financially feasible use that produces the highest financial return is the highest and best use.
Once the highest and best use is determined, the appraiser can then estimate market value. Appraisers use three basic approaches to estimate market value: the sales comparison approach, the cost approach, and the income approach, using either the Direct Capitalization Method or the Discounted Cash Flow Model.
Sales Comparison Approach
The sales comparison approach links the value of a property to prices that recent buyers have paid for similar properties. In reality no two properties are exactly alike, but this approach can provide a reasonable estimation of value when there is a large quantity of recently sold comparable transactions.
Cost Approach
The cost approach bases value on the cost of reproducing a property, less any accrued depreciation. Accrued depreciation can come from three sources: physical deterioration, functional obsolescence, and external obsolescence. Once the replacement cost is determined and the accrued depreciation is netted out, the cost is added to the value of the land to estimate an appropriate value based on cost.
Income Capitalization Approach
The income approach to market value derives property value from the income it produces. The two methods used to value a property based on income are the direct capitalization method and the discounted cash flow valuation method.
- Steps for Direct Capitalization:
- Estimate net operating income (NOI).
- Determine the cap rate from market data, comparable sales, or investor surveys.
- Apply the cap rate: Value = NOI/Cap Rate
- Steps for Yield Capitalization (DCF):
- Forecast NOI each year of the holding period.
- Estimate resale value with a terminal cap rate.
- Determine the discount rate from market data, comparable sales, or investor surveys.
- Discount future cash flows to get a present value.
Reconciliation of Value
For income-producing commercial properties, the Income Approach is king, but often all three methods inform an appraiser’s final opinion. If more than one method is used, then they are typically reconciled by using a weighted average to determine the final value estimate. For example, it may be determined that a higher weight should be given to the income approach because the available comparable sales data is weak. As such, this would be reflected in the final reconciled market value in an appraisal.
Approaches to Investment Value
While the market value is used in appraisals for loan underwriting purposes, investors also consider how much a property is worth, given their unique perspective. Investment value is the amount that an investor would pay for a specific property, given that investor’s investment objectives, business plan, and other unique factors including target yield, and tax position.
Because investment value depends on an investor’s point of view, investment value is unique to the investor. As such, different investors can apply the same valuation methods and still come up with different investment values. Investors can choose from a variety of valuation methods when determining investment value, unlike appraisers who have to adhere to strict procedural guidelines. The following are the most common ways used to determine investment value:
Cash on Cash Return
The cash on cash return is simple ratio used to determine investment value. It’s calculated by taking cash flow before tax and dividing it by the total equity invested. This is commonly used by non-institutional investors when estimating investment value because it’s simple to understand. It can also be used in combination with other methods.
Equity Multiple
The equity multiple is the ratio of total cash distributions received from an investment, divided by the total equity invested. This is also commonly used by both institutional and non-institutional investors when estimating investment value. It is typically used in combination with a discounted cash flow analysis.
Comparable Sales (Comps)
This is the same sales comparison approach mentioned above that is used by appraisers. Typically, investors will compare similar properties on a per square foot or per-unit basis. This is usually used along with other methods.
Direct Capitalization
This is the same direct capitalization approach mentioned above that is used by appraisers. Capitalizing an estimate of stabilized net operating income for a property is a common and simple way to determine both market and investment value for a commercial property.
The key difference between market value and investment value is that investors may forecast a different stabilized net operating income, based on their unique perspective, plan, or advantages. This contrasts with appraisers, who aren’t considering a unique perspective, but rather trying to estimate the typical or market average perspective. For investment value, the cap rate is typically used as a starting point for a back of the envelope analysis, before moving on to a full discounted cash flow model.
Discounted Cash Flow
The discounted cash flow model is the most widely used method for determining investment value, especially among institutional investors. A DCF analysis involves projecting future cash flows using a detailed proforma. Then, depending on your objective, you either discount these cash flows at a specified rate to calculate Present Value and Net Present Value (NPV), or solve directly for the discount rate that sets the NPV equal to zero, known as the Internal Rate of Return (IRR).
Key Questions Answered by a DCF Analysis:
- Present Value answers the question: “What is this investment worth to me today given my required return?”
- IRR answers the question: “What return am I actually earning based on these cash flows?”
- NPV answers the question: “How much more or less can I pay given my required return, assuming all else remains the same?”
Understanding DCF: Market vs. Investment Value
The key distinction between market value and investment value in a DCF analysis lies in their different objectives:
- Appraisers (Market Value) typically perform a DCF analysis to estimate the present value (PV) of future cash flows using generalized, average market assumptions. The goal is to determine what a typical buyer would pay under standard market conditions, without considering specific financing or personal investment criteria.
- Investors (Investment Value) typically focus on finding the equity Internal Rate of Return (IRR) rather than explicitly calculating present value. Investors consider their specific property plans, financing structure, and personal return requirements. They iteratively solve for the maximum purchase price that achieves their targeted equity IRR.
Investment value, practically speaking, is determined by adding Debt + Equity at the purchase price that achieves the investor’s target equity IRR.
Levered vs Unlevered DCF Analysis
A levered DCF reflects how financing impacts the investor’s returns, while an unlevered DCF isolates property performance without financing.
Unlevered DCF:
- Starts with NOI, discounts future NOI and terminal value to present.
- Calculates Present Value, NPV, or IRR without financing impact.
Levered DCF:
- Begins with NOI, subtracts debt service to find cash flow before tax.
- Discounts equity cash flows (after debt service) and net sale proceeds after loan repayment.
- Calculates Present Value of equity, NPV for equity, or Equity IRR.
Appraisers typically calculate the present value using unlevered cash flows. Investors focus on levered analysis as it directly relates to their specific requirements and assumptions.
Determining Investment Value and Iterating to a Maximum Purchase Price
In practice, when an investor builds a DCF model, what they are really after is the equity IRR – the rate of return on the actual cash investment. Investors rarely begin by explicitly calculating the present value upfront. Instead, they typically determine the purchase price through an iterative process, adjusting the price and related variables until their target equity IRR is met.
If the projected cash flows meet your equity return requirements, then the investment makes sense and you can proceed. However, this just tells you the IRR on your equity investment. Strictly speaking, the investment value is the sum of all debt and equity, which amounts to the total cost of acquisition. This includes the purchase price plus all acquisition fees and upfront expenses, which must be funded with either debt or equity. In other words, once you find a purchase price that generates your desired equity return, your investment value simply equals Debt + Equity.
But what if your equity IRR isn’t where you want it to be, and you need to find the maximum purchase price you can pay for the property? Calculating an NPV for your equity can point out how much you’re off by in theory, yet it assumes no other variables change when you tweak the purchase price by the NPV. Net Present Value assumes “all else equal” but that’s rarely the case in real-world transactions.
Why NPV Fall Short
NPV helps investors estimate how much more or less they can pay but assumes all other variables remain constant. However, adjusting the purchase price can affect:
- Loan-to-Value (LTV) ratios
- Closing costs, property taxes, insurance, and related expenses
Imagine a $1,000,000 property financed at 80% LTV ($800,000 loan) plus $200,000 in equity. If your NPV suggests the equity is only worth $100,000 at your discount rate, you might think you can simply reduce the total price to $900,000 and commit $100,000 of equity. But if you keep the same $800,000 loan, that’s now almost 88% LTV – likely a deal breaker for your lender. If you drop the loan to 80% LTV ($720,000), then you’re back at $180,000 in equity, which doesn’t accomplish what you wanted.
It’s not just the loan that changes, either. Acquisition fees, closing costs, and property taxes often scale with purchase price. So when you alter the property’s price, those items shift as well, which can in turn impact your cash flows.
The most practical way to get around this problem is to reverse engineer the purchase price by iteratively adjusting it until your target equity IRR is acheived.
The Iterative Method
- Start with an Initial Purchase Price Guess: Pick a number and plug it into your levered model.
- Check the Equity IRR: If the IRR exceeds your target, you have room to pay more. If it’s below, you need to pay less.
- Update Key Assumptions: Update the loan amount (making sure you stay within LTV limits), along with fees, closing costs, and any other expenses tied to the purchase price.
- Refine and Repeat: Continue adjusting the price—and all affected inputs—until your equity IRR aligns with your goal.
When the equity IRR matches the investor’s requirement, the corresponding total acquisition cost (Debt + Equity) defines the property’s investment value.
Example
- Target Equity IRR: 15%
- Initial Price Guess: $5M yields 18% equity IRR. Since this exceeds the target IRR that means there is room to raise the purchase price.
- Refine: Raise the purchase price and update assumptions until IRR hits 15%.
- Result: The final price is your maximum feasible purchase price.
An NPV analysis can help you guess how much to raise or lower your price between each iteration, but you still need to check how those changes influence your financing and other assumptions.
Sometimes you are also trying to solve for more than one metric. For example, it is common for investors to back solve for a purchase price that both meets a minimum IRR and a minimum equity multiple. Other times, smaller non-institutional investors may simply solve for a purchase price that achieves a minimum cash on cash return. These differences in perspective are ultimately why investment value is unique to each investor.
Conclusion
The distinction between market value and investment value is fundamental to understanding commercial real estate valuation. While market value represents the most probable price a property would command in an open market under fair conditions, investment value reflects what a specific investor would pay based on their unique circumstances, requirements, and objectives. This difference explains why different investors might assign varying values to the same property.
The methods used to determine these values — from the traditional approaches of sales comparison, income capitalization, and cost analysis for market value, to investment metrics like cash-on-cash return, equity multiple, and IRR — provide a comprehensive toolkit for valuation. Making informed decisions in commercial real estate investment requires not only mastering these valuation concepts but also understanding how they interact with each other and knowing when to apply them appropriately. Whether you’re an institutional investor or private investor, recognizing the relationship between market value and investment value – and knowing how to calculate both – is fundamental to making sound investment decisions.