Before you can start trying to acquire a property, it is important to understand how commercial property is valued. After all, how do we know if we are REALLY making money on a commercial property if we don’t know how much the property was worth in the first place?
The #1 most important rule for evaluating Commercial Properties is this: They are based on the income they generate.
For those coming from the single-family home investing world, this is a shift in mentality. Single family houses are generally assigned a value based on the recent sales prices of similar houses nearby (sometimes known as “comps” or “market comparables”). With commercial property, however, it can be extremely difficult to find a similar property nearby.
For example, if you came across a 24,000-square-foot, 3-story building with retail on the first floor, offices on the second floor, and apartments and storage on the third floor, your chances of finding another building with the same layout and use next door, or even in the same city, might be close to impossible. Similarly, it’s difficult to compare a 40-unit apartment high-rise building (with all the units in one tall building) with a 40-unit apartment garden-style complex (where you might have 10 one-story buildings with four units each spread out over a much larger area).
Thus, commercial property is best valued by the NET OPERATING INCOME (aka “NOI”) it produces. Figuring out the NOI is very simple when you have all the numbers: you simply take the actual income of the property (all the rental and non-rental income combined) and subtract the operating expenses, and you get the Net Operating Income. The NOI is the income the property produces BEFORE paying any mortgages.
Market comps and replacement value do play a part in valuing commercial property, but the TRUE value is found by determining the NOI.
Many investors would be very happy with a 10% return on their money. For example, let’s say a property generates $100,000 in NOI. Investors in most parts of the country would gladly pay $1 Million to buy a property with a $100,000 annual income stream (a 10% return). This desired return on investment is also known as a “cap rate”.
Thus, as a (very general) rule of thumb, you can take the NOI of a property and divide by 10% (or an appropriate CAP rate for the market you are evaluating) to determine the value of the property. If you were able to find a way to increase the NOI on that same property from $100,000 to $150,000, the property would rise in value from $1 Million to $1.5 Million (based on a 10% cap rate).
So here’s the basic formula: NOI/CAP=Value
It’s pretty basic but has huge implications for your Commercial investing career!
You should contact a local banker or broker, and do some market research to get an idea out the actual cap rates for your specific area.