Now that you have made the decision that commercial real estate is the ticket to a well diversified portfolio, you begin the search for the perfect asset. There are many different assets to choose from in commercial real estate: office buildings, industrial warehouses, strip malls, apartment buildings and even the post office building!
Just as you get your feet wet looking at the vast array of possibilities, you may discover that deciding how much you are willing to offer on each of these assets is becoming a little bit of a challenge. Some of the properties your broker has sent you don’t even have an asking price! The listing broker only says something like: offered at market rate. So now, you not only have to find just the right property for your investment appetite, you also have to determine how much it’s worth.
You aren’t a real estate appraiser you say? That’s okay; we’re going to explore how the majority of commercial real estate brokers, investors, bankers, and maybe even appraisers come up with their estimated value of a commercial real estate asset.
First, let’s remove all traces of residential real estate valuation from that head of yours. Using what you know about residential real estate to help you value commercial real estate is going to really get you off on the wrong foot.
You may recall from previous blog posts that commercial real estate does not have a central ‘For Sale’ repository like residential real estate does. There is no MLS for the commercial side of the house. Next, and perhaps most importantly, in commercial real estate, we do not use comps. You know; comps. Comps are the way we all determine how much our personal residence is worth when we are looking to purchase or refinance. We compare houses with the same number of bedrooms, bathrooms, and square feet to our current or prospective home. We then look at these ‘comparable’ houses within a tight radius, closest to our current date.
Yeah, comps are not really used in a serious way for commercial real estate. At best, you could use this kind of information as a tool to see generally how far away from, or how close, your property’s asking price is from properties that have closed escrow. Be warned, however, that you may or may not find recent sales or sales of very similar property types, and therein lies the limitation in using this method for anything other than as a reasonableness test.
Another method of valuing commercial real estate is replacement cost. This method is not used much anymore, and is not talked about too much. The one place you will see a reference to a replacement cost is in a sales listing where the broker might say something like ‘priced well bellow replacement cost’. Replacement cost is just like it sounds, it’s the cost of re-constructing the commercial real estate asset from the ground up(though not including ‘the ground’). There are a couple of ways to go about this type of calculation, but a typical calculation is based on an average dollar value per square foot. As with comps, the replacement cost calculation can be used for reasonableness testing.
The gold standard, if you will, for valuing commercial real estate, however, is Net Operating Income, or NOI. NOI, used in combination with CAP rate, gives you the potential acquirer, the estimated value of an asset and a great starting point for presenting an offer or negotiating a position.
Net operating income is defined simply by the gross operating income of the property, i.e. all rental income plus other income the property generates, minus all of the asset’s operating expenses. Please note that this calculation does NOT include mortgage payments of any type. Once this value is determined, and a CAP rate is known, it is a straight forward calculation to determine an offering price.
What is CAP rate you ask? This is an important question when working the formula we’ll discuss in a moment. The CAP rate, or the capitalization rate is the unleveled return you would expect to find your market or submarket for your particular asset type. For instance; in Dallas, TX, we might expect to find CAP rates in the 6% rage as of this writing for a B-class multi-family asset. The same B-class multi-family asset in San Francisco, CA may currently be fetching 3.5%.
The lower the CAP rate in a particular market, say in San Francisco, CA, the more secure and stable the asset. The higher the CAP rate, the greater the intrinsic risk. Generally speaking, there are CAP rate ranges for each class of assets within each market. Your commercial real estate broker should have the most current CAP rates available for your asset type and class.
The calculation: Once we have a handle on the NOI and know the going CAP rate, the value calculation is fairly straight forward. We divide NOI by our CAP rate, which looks like this:
NOI / CAP Rate = Asset Value
Here is an example. Our NOI is $500,000 and the going CAP rate is 6% or .06. We plug and play:
$500,000 / .06 = $8,333,333
This calculation is easily swapped around to find any of the three variables if we have the other two. This makes this calculation handy for learning more about our market and its expected returns and/or understanding the financial performance of a commercial asset.
As with any calculation; there are some pitfalls, particularly in the NOI derivation. We will explore those limitations in a future blog post. Beyond those pitfalls, NOI/CAP rate valuation calculation and all of its flexibility, makes it stand head and shoulders above any of the alternate calculations out there.
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