Commercial Real Estate Valuation 101
When first approaching the process of valuation for commercial real
estate, it is important to distinguish between properties
purchased for appreciation and those purchased to generate income.
While a property can certainly satisfy both, it's best to calculate
these values separately.
Appreciation can be thought of as a bet. Most investors will spot an
up and coming city or area and purchase undervalued property.
Generally, the best bet is when the surrounding area is growing and
increases property values. Bets like this are important to consider,
but very hard to predict.
Subsequently, most calculations for commercial real estate
valuation are based upon the income of the property. The
Capitalization Rate - the amount of money a property earns
per dollar invested is particularly important. This ratio
provides a clear return on investment number, which we can compare
directly to other properties. It is much harder to compare absolute
property metrics such as price.
So how do you calculate this for your potential commercial
investment? The primary method we use to valuate commercial property
is the Income Method, which consists of three
simple steps:
1 - Find Average Capitalization Rates in your Market
Look at some recently sold properties and calculate their
capitalization rates to find an average range for the property type
you are looking at. It is important to pick something of the same
class (apartment/office building/warehouse, etc.) in the same local
market.
The basic equation for capitalization rate is:
Capitalization Rate (a.k.a., cap rate) = Net Operating Income/Sale
Price
Net Operating Income = Gross Operating Income - Operating Expense
Example: We are looking at apartment complexes in Washington
State. So, we will use three similar commercial real estate
properties to calculate an average Capitalization Rate for this
class of investment:
| Price |
Net Income |
Capitalization Rate |
| $795,000 |
$79,200 - $32,980 = $46,220 |
$46,220/$795,000 =
0.0581 or 5.81% |
| $440,000 |
$65,520 - $28,972 = $36,548 |
$36,548/$440,000 =
0.0831 or 8.31% |
| $325,000 |
$23,100 - $2,966 = $20,134 |
$20,134/$325,000 =
0.0620 or 6.2% |
|
Average Cap Rate for Apartments in Washington
State valued between 0 and 1 Million Dollars |
(.581+.831+.620)/3=
0.0677 or 6.77% |
Average Cap Rate for Apartments in Washington State Worth between
0 and 1 Million Dollars (.581+.831+.620)/3=0.0677 or 6.77%
Now we have our average market capitalization rate = 6.77%. This is
a fairly typical number for apartment complexes in Washington State
- capitalization rates tend to vary between 6% and 10% across the
board. If you want to give this a try, just visit cimls.com and look
at the properties for sale in your area. Be sure to remember that
this will give you an average Capitalization Rate for the asking
price - not the selling price (typically resulting in a lower
average).
2 - Find the Net Income
Net Income (property revenue minus expenses) is often posted
on cimls.com. If it is not readily available, you should be
able to ask the seller directly for this information. Do not
accept pro forma numbers (estimated) or Gross Potential Income
(total income "as if" the property was fully occupied). Also, keep
in mind that these numbers are estimates - typically designed only
for initial ballpark valuations. When you make a final offer, be
sure to use the actual income numbers from the operating statements
of the last year or two.
Example:
We are looking to valuate an apartment complex in Washington State
where the asking price is $550,000. By viewing the financial section
of the property information from cimls.com, we find the income is
$80,000, and expenses are $30,000.
3 - Calculate Property Value
Now that we have the Net Income and an average capitalization rate,
we simply perform the calculation:
Example:
Now we know:
Average Cap Rate for Apartments in Washington = 6.77% (from Step 1)
Property Net Income = $80,000-$30,000 = $50,000 (from Step 2)
We plug the numbers in to this equation:
Net Income/Capitalization Rate = Property Value
$50,000/.0677 = $738,552
*Be sure to convert percentages into decimals. Otherwise, you will
be off by a factor of 100!
Based on our calculations, this looks like a steal! Our valuation
shows that the property in question is worth almost twice the asking
price!
This is not just a fantasy - it happens all of the time in the
commercial real estate world. There are a myriad of reasons why this
is the case (high risk property/owner needs to liquidate assets,
etc). However, it is critical to take the time to understand why the
property is undervalued. Just remember - the owner can do these
calculations as well!
Other Methods
The Income Method (above) is our preferred calculation, but there
are many other ways to valuate a property. It is always a good idea
to look at several of these factors to find inconsistencies. Each
unexpected result represents a risk or an opportunity. As an
investor, it is your choice whether or not to take it - but it is
important that when you take on any risks, you do so intentionally!
Two other valuable methods for commercial real estate valuation
include:
The Comparison Method
Look at the quoted price compared to properties with similar prices
and prices per square feet or prices per unit in the same market.
Replacement Cost Method
Use the comparison method to estimate the value of the land. Then,
make an estimate of how much it would cost to build the structure -
discounted by wear and tear (depending upon how old the building is.
This gives you the cost of replacing this building. Especially for
essential structures - like the grocery store in a small town - this
can uncover some diamonds in the rough. If the property is
undervalued by this method - business owners will prefer to buy your
property or rent from you rather than building a new building!
While the Income Method is the most concrete method, there really is
no hard and fast rule to valuating commercial real estate. Methods
and results will vary widely across market and property type. The
key for an investor to keep in mind is that any numbers that stick
out - any aberrations - represent risk. This risk carries with it
potential for failure and success. As always, it is up to you as the
investor to determine whether or not the risk is worth taking.
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