The Formula, and Why It Is Not the Hard Part
For any income-producing commercial property, value comes from one equation:
Value = Net Operating Income / Cap Rate
That is the income approach, and it is how essentially every institutional buyer, lender, and appraiser arrives at a number for an apartment building, a self-storage facility, a strip center, or an office building. A commercial property is not valued the way a house is. Nobody cares what the building next door sold for on a price-per-square-foot basis if that building produces different income. A commercial building is a stream of cash, and the price is what that stream is worth today.
Which means the formula is not where owners get into trouble. Everyone can divide. The trouble is that both inputs are estimates, both are contested, and both are easy to flatter without noticing. An owner who is off by four points on the expense ratio and 75 basis points on the cap rate is not off by a rounding error. On the example below, they are off by more than a million dollars on a five million dollar building.
So the useful version of "how much is my building worth" is really two narrower questions. What is the NOI a buyer will underwrite? And what cap rate is that buyer's market actually clearing at right now?
Step 1: Get to an Honest NOI
Net operating income is the property's income after operating expenses and before debt service, capital expenditures, depreciation, and taxes on income. The order matters, and each line has a way of going wrong.
Start with gross scheduled rent, which is what every unit would produce if fully leased at current asking rents. This is a theoretical number and it is not your income. Subtract vacancy and credit loss. Use what the property actually experiences, and if the building has been fully occupied for a year on paper, check whether that includes units occupied by non-paying tenants. Then subtract loss to lease, the gap between what units are leased at and what they could be leased at today, because in-place leases are the income a buyer inherits. Add back other income: parking, laundry, storage, pet rent, application and late fees. On a well-run multifamily property this is not trivial and owners routinely leave it out.
What you now have is effective gross income, which is the number expenses should be measured against.
Then subtract operating expenses: property taxes, insurance, utilities, repairs and maintenance, turnover, contract services, payroll, marketing, administrative, and property management. Two of these are where owner NOI reliably comes in too high. If you self-manage, a buyer will still underwrite a management fee, typically 3 to 5 percent of EGI, because the buyer will have to pay one. And a reserve for replacement, often $250 to $400 per unit per year on multifamily, gets deducted by most buyers and every lender whether or not you have ever funded one.
Do not subtract your mortgage payment, your capital improvements, or depreciation. Those are real costs to you and they are not part of NOI, because NOI describes the asset rather than your particular financing and tax position. This is precisely why two owners of identical buildings can hold very different amounts of equity and the buildings are still worth the same.
One more decision, and it is the one buyers and sellers argue about most: trailing or pro forma. Trailing NOI is the last twelve months of actual performance, which is what the T-12 shows. Pro forma NOI is what the property would produce after you raise rents to market, fill the vacancy, and cut the expenses you have identified. Owners value on pro forma. Buyers pay on trailing, then underwrite the upside themselves and keep it, because the upside is the return on the work they are about to do. Valuing your building on pro forma NOI is the single most common reason an owner's number is 15 to 20 percent above where the market clears.
Step 2: Find the Cap Rate a Buyer Would Actually Pay
The cap rate is the unlevered yield a buyer requires on the income. Lower cap rate means a higher price for the same income. It is set by the market, not by you, and it moves with interest rates, the perceived risk of the asset, and how much capital is chasing that asset class in that submarket right now.
Getting it right comes down to matching on four dimensions at once, and most bad cap rate estimates fail on at least one:
Asset class and subtype. Multifamily, industrial, retail, office, and self-storage do not trade at the same yields, and neither do Class A and Class C within one of them. A 1968-vintage garden apartment does not trade where a 2022 mid-rise trades.
Submarket, not metro. Cap rates inside a single metro area vary meaningfully by submarket. The county-level average is a starting point, not an answer.
Closed sales, not listings. This is the important one. The cap rates in marketing brochures are asking-price cap rates, and asking prices are aspirational. Use cap rates from transactions that actually closed. A market where listings show 5.25 percent and closings show 5.9 percent is a market where the gap is the negotiation, and if you value off the listings you will price yourself out of it.
Recency. Cap rates from eighteen months ago describe an interest rate environment that may no longer exist. Rate movements reprice assets quickly, and the direction of cap rate movement matters as much as the level.
Sources worth using: closed comparable sales from a broker who works your submarket, agency loan data from Freddie Mac and Fannie Mae for multifamily, and public filings from REITs that own similar assets nearby. What is not a source is your county's assessed value, which is a tax-assessment artifact and is frequently off by a wide margin in either direction.
Step 3: Divide, Then Sanity Check
Do the division, then immediately check the answer against a second unit of measure. Price per unit for multifamily, price per square foot for industrial, retail, and office, price per net rentable square foot for self-storage.
The reason this matters: if the income approach hands you $340,000 per unit in a submarket where comparable buildings have been trading between $190,000 and $230,000 per unit, something upstream is wrong. Usually the NOI is pro forma, or the cap rate came from a different asset class. The two methods should land in the same neighborhood. When they do not, believe the one built on closed transactions.
Also check the implied gross rent multiplier and the expense ratio. A multifamily expense ratio below about 35 percent of EGI is unusual and worth interrogating. Above about 55 percent suggests either a real operational problem or a building that is mis-classified.
A Worked Example, Start to Finish
A 24-unit apartment building. Units are leased at an average of $1,850 per month. Here is the full path from rent roll to value.
| Line | Amount | Note |
|---|---|---|
| Gross scheduled rent | $532,800 | 24 units x $1,850 x 12 months |
| Vacancy and credit loss | ($31,968) | 6 percent, in line with submarket |
| Other income | $14,400 | Parking, laundry, pet rent, fees |
| Effective gross income | $515,232 | What expenses are measured against |
| Operating expenses | ($216,397) | 42 percent of EGI, includes management fee and reserves |
| Net operating income | $298,835 | Before debt service and capex |
Now apply the market cap rate. Closed sales of comparable 1970s-vintage garden apartments in this submarket over the last two quarters have been clearing at 5.75 percent.
$298,835 / 0.0575 = $5,196,000
Round to $5,200,000. Divide by 24 units and the sanity check gives $216,500 per unit. If closed comparables in the submarket have been trading between $195,000 and $230,000 per unit, this number is credible and you can stop here. If they have been trading at $150,000 per unit, go back and find out which input is wrong.
How Much the Two Inputs Actually Move the Answer
This is the part worth internalizing, because it tells you where to spend your effort. Hold everything else constant and move one input at a time.
| Change | Value | Difference |
|---|---|---|
| Base case, 42 percent expenses, 5.75 percent cap | $5,196,000 | base |
| Cap rate 5.25 percent | $5,692,000 | +$496,000 |
| Cap rate 6.25 percent | $4,781,000 | ($415,000) |
| Expenses 46 percent instead of 42 percent | $4,839,000 | ($358,000) |
| Vacancy 10 percent instead of 6 percent | $4,982,000 | ($214,000) |
A 100 basis point range on the cap rate, which is an entirely ordinary amount of disagreement between a buyer and a seller, is a $910,000 spread on a five million dollar asset. That is 18 percent of the value of the building, decided by one number that neither party controls.
Four points of expense ratio, which is roughly the difference between an owner who self-manages and forgets to underwrite a management fee and one who does not, is $357,000. Combine an optimistic cap rate with an optimistic expense ratio and an owner arrives at $5.69 million while the market arrives at $4.84 million, and both people believe they did the arithmetic correctly. They did. They disagreed about the inputs.
The Other Two Approaches, and When They Govern
The income approach is dominant for anything that produces rent, but it is one of three recognized methods, and there are situations where it is the wrong one.
The sales comparison approach values the property against recent sales of similar properties, adjusted for differences in size, condition, location, and vintage. This is how houses are valued and it governs commercial property in three cases: small buildings where income history is thin or unreliable, owner-user properties where the buyer will occupy rather than rent, and any property where the income is so distorted by vacancy or below-market leases that capitalizing it produces nonsense. It is also the sanity check on the income approach, which is why price per unit matters.
The cost approach values the property as the cost to buy the land plus the cost to rebuild the improvements, less depreciation. It rarely governs for stabilized income property, because a buyer does not care what it cost to build. It matters for new construction, for special-purpose buildings with no meaningful comparable set, and for insurance purposes, where replacement cost is the whole question.
An appraisal will typically develop two or three of these and reconcile them, weighting whichever is best supported by the available evidence. For a stabilized apartment building, that will be the income approach, supported by the sales comparison as a check.
Five Ways Owner Valuations Go Wrong
1. Valuing on scheduled rent instead of collected rent. The rent roll shows what units are leased at. The bank statements show what came in. If those two numbers differ, buyers use the second one. Loss to lease and concessions are real reductions in income.
2. Leaving out the management fee and the reserve. If you self-manage, your expenses really are lower than a buyer's will be, and that lower number is not what the building is worth. A buyer underwrites 3 to 5 percent of EGI for management and a per-unit reserve regardless of how you have run it.
3. Using asking-price cap rates. Listings are the seller's opinion. Closed sales are the market's. In a market that has been repricing, the gap between the two is often 50 to 75 basis points, which on the example above is most of half a million dollars.
4. Charging the buyer for your business plan. Pro forma NOI prices in rent increases you have not achieved and expense cuts you have not made. The buyer's return comes from doing that work. Selling on trailing NOI and letting the buyer pay for in-place income is not leaving money on the table, it is how the transaction clears.
5. Anchoring to the assessed value or to what you paid. The county's assessed value is a tax figure and routinely diverges from market value in both directions. What you paid in 2019 tells you about 2019. Neither is evidence about today.
BOV vs Appraisal vs Automated Valuation
Three ways to get a number, with different costs, speeds, and reasons to trust them.
| Method | Cost | Turnaround | Use it when | Watch out for |
|---|---|---|---|---|
| Broker opinion of value | Free | Days | You want submarket knowledge and are considering selling | The broker wants the listing, which is an incentive to come in high |
| Appraisal | Commonly $2,000 to $10,000 | Two to four weeks | You need a defensible number for a lender, a partner buyout, an estate, or litigation | Slow and expensive for a question you are still exploring |
| Automated, comp-implied | Free to low | Seconds | You want a first read, or a check on the other two | Only as good as its comparable set and how current the data is |
These are not substitutes so much as a sequence. Start with an automated read to know whether you are in a conversation worth having. Get a BOV or two if you are seriously considering a sale, and read them against each other. Pay for an appraisal when a number has to survive scrutiny from someone whose money is on the line.
How to Check Your Number in Two Minutes
Once you have worked through the arithmetic above, the useful next step is a second opinion built from a different data source, because the failure mode of doing this yourself is that you check your cap rate against the same brochures that gave you the cap rate.
ValueMyDeal is a free tool that does this. Type a US property address, pick the asset type, and it returns a comp-implied value, the going-in cap rate against the class-matched local band rather than a metro average, a market signal score, and the risk flags an offering memorandum tends not to lead with. It is built on filing-grade sources: SEC EDGAR, Freddie Mac and Fannie Mae agency loan data, and Census data. No login and nothing to install.
The point of running it is not to replace your own work. It is to see whether your cap rate assumption and the market's agree, because that is the input with a $910,000 range on a five million dollar building. If the two numbers are close, you have a defensible valuation. If they are far apart, you have found the assumption to go argue about before a buyer finds it for you.
For teams doing this across a pipeline rather than on one asset, the same problem shows up at scale: every offering memorandum arrives with the seller's cap rate and the seller's pro forma, and checking each one by hand is where analyst weeks disappear. That is the job assumption validation in an acquisitions operating system does automatically.