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How To Value Commercial Real Estate

By Gary L. Smith

Given enough time all real estate deals are profitable, however it is a known fact everyone loses money in real estate at some point. But in order to mitigate your risk, how do you determine how much to pay for a property?

How do you decide what a building is truly worth both in today’s market and at some point in the future?

 

How do you know what a property is really worth? 

There are basically three ways to evaluate real estate. The Sales Comparison method, commonly referred to as “comps” is primarily used in residential real estate. Basically you determine the value of one property in a given area by the sales of similar properties within a specific time frame, typically six months. 

Another approach to determining value is the Replacement Cost method. Whenever you use this approach you must find out how much does it costs, to build a brand new building with the same quality of materials, location, etcetera, as the one you’re buying.  It’s generally acceptable if your costs are lower than the cost to build new. 

Then there is the Capitalization method (CAP Rate). This method is used over 90 percent of the time when it comes to commercial real estate, because what you are buying is an income stream. By taking the income of a property and dividing it by the price you arrive at the Capitalization or CAP Rate. 

Another way of looking at cap rate is that if you were paying all cash for a property, then the cap rate is the actual return you’re receiving on your investment. Knowing the cap rate in a particular market or for a particular property type is critical to determining value. 

This column will focus on the Capitalization Method or what I like to call the Income Approach. The income approach to valuing a building is used to determine whether you can make money or not, before you even see the property. 

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Article On How to
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When determining value for commercial investment properties, most jurisdictions use the income generated by the property as the prime indicator of what the value is. This is particularly true in net lease properties, where retail stores that are out of operation can still generate income for the Landlord.

Let’s say you found a property that is located at the busy intersection of Gratiot and Eight Mile, the location is great. Thousands of cars pass that intersection every day. The building you’re interested in is occupied by a tenant who is e-commerce resistant and necessity based. They are willing, able and ready to pay all the expenses associated with operating that building. Your tenant is a billion dollar company who can well afford the rent you charge. 

Immediately, companies like T-Mobile, Captain D’s, Verizon, Dominoes, or Little Caesar’s Pizza come to mind. 

Here’s how you determine the value of this property.  As most of us know, you don’t get something for nothing. There is risk in every investment… real estate is no different. However, the lower the risk, the lower the return. The higher the risk, the higher the return.

There obviously isn’t much risk involved in the scenario I described above, you merely spend the money the tenant pays you until they move. If they move before the term of the lease is up, they still have to pay you the rent until the lease expires. If they decide to remain after the lease terminates, then they sign a new lease at a new rate… wash, rinse, repeat!

Deals like this often come at a 5 or 6 percent cap rate. If the property is selling for $1,000,000 and the cap rate is 6 percent, the income stream is $60,000. However, deals like this in Metro Detroit typically sell at 7 percent, which means the real value of the property is closer to $857,143. 

Before moving forward with an acquisition, the question that must be asked is, am I buying the property because of the income it produce, or the location of the real estate? 

Your biggest risk in real estate investing is the unknown, what you don’t know. You should always be looking for real estate located in a densely populated area, with strong employment and strong rent growth. You want a property that can be purchased at or below replacement cost. Buy where the rent is at or below market rent. Either way, you’re happy if the tenant stays, you’re happier if they leave. 

Remember, cash flow is real estate’s, real value! It’s the most accurate assessment of value. 

The game of real estate is quite simple; figure out what something is worth, then pay a lot less for it! 

Always remember the cash flow from real estate is only as stable, dependable and predictable as the tenant who pays the rent. 

The ultimate goal of the real estate investor is to eventually increase rents and improve total cash flow of the property and sell. The extra cash flow can be used to pay off debts, acquire more properties or supplement income. 

Never buy real estate for appreciation. Always buy real estate for cash flow.  When you buy for cash flow, you don't care what the market is doing. If you buy for appreciation, inflation can ruin your strategy. 

Real estate is all about cash flow! Value becomes a by-product and yet it’s a critical component to successful investing.

Understanding a deals’ ability to withstand bad times is important. Protect the downside and the upside will take care of itself.

Focus on real estate fundamentals and think about whether the returns are being generated from the real estate itself or risky financial engineering, (aka, “Creative Financing”). 

Look for opportunities for growth and expansion, but don’t overpay for it!

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