How to properly value real estate and use a commercial broker

Question

Hi all, I'm interested in purchasing this office commercial real estate in Western Washington. There's a small medical/dental business on the lower floor (~2k sq ft) and an upper floor (1k sq ft) that sits empty. Its asking price is 800k.

I understand there's some ways to come with a valuation 1) cap rate 2) comps 3) build. The selling broker seems to be valuing it high since the building next door is larger by 2k, larger lot and sold for $1 million. I hired a local broker and he pulled some comps and agreed that it was a good offer. But if we're looking at the cap rate/income that changes since the top floor is not leased, and the building has not been updated for a long time.

1) How do you take into account the building being old (1990) and hasn't been updated?

2) I understand that having it leased is an important factor. The comps could have had long leases that I don't know about. How does the top floor not being leased for a long time affect the valuation?

3) The lease for the business below ends next year. The current rate is possibly a little higher than comps, especially since it's a medical/dental business, so in the future to lease it out, the new tenant would likely want lower $/sq ft for longer term.

4) How do I make sure my broker is representing my best interest?

I'm sure commercial real estate is pretty localized and my broker knows the selling broker and are currently working on a different deal (not together).  My broker walked through the building with the selling broker and talking to me afterwards he mentioned the "potential" $/sq ft the units could rent for, which were the exact same numbers the selling broker had for his cap rate valuation (which I didn't share with my broker). Thanks for any insight.

John McKee · Answer

Well if you are the owner/operator running your business you may not care about cap rates, potential upside etc.  You just want a place to operate your business where you can control your rent.  It just depends on your perspective and what you are trying to do.

John McKee · Answer

As an investor you have to evaluate it based on the income that the one unit generates and hope that you can increase the value by renting out the second unit.  However the building could be for sale based on market value or potential income and not the actual income.  If that is the case i would walk away unless I was an owner/operator of the space.  If they are trying to sell you on the potential income you may as well invest in a NNN property with no upside that has guaranteed income with a long term lease.

Michael K Gallagher · Answer

@Carl Cheung if you are planning to "office hack" this building then the returns may not mean as much to you.  but to address the improvements that need to be made and such, Its my expierence that the selling number does not matter to the seller as much as the "net to seller" so even though they want the $800K theres always room in there to ask for closing credits to address the things you are seeing on the facade of the building.

Additionally if you are worries about inheriting a vacant building or the whole building going vacant in my mind then you are analyzing the entire building and area as an investment, so what is the population trends, for that area, any data or comps on that asset class as far as per sf rents.  It's then a question of does this thing make sense if I have to operate it from the ground up basically.  But to other's points here, even if the numbers work and look promising having a lender lend on a building not producing any income or at risk of not producing any income will then be your biggest issue.

Paul Moore · Answer

@Carl Cheung. So you are saying you might want to run your business out of the current space, correct? Have you spoken with the current tenant to ask them about their intention to renew the lease? If you want them to renew, I wonder if you could somehow draw up hey binding agreement to sign in advance with their renewal based on you closing. If they renew, could you run your business out of the other floor thereby filling the whole space?

You are right to look at the income and caprate. I wouldn’t pay much attention to the comp next door nor the dollars per square foot. You might want to talk with a few lenders and get their take on the value and their willingness to loan on it.

I’ve written quite a few articles on the topic of commercial real estate value. I can’t locate the best one right now but here is a recent example: https://www.biggerpockets.com/...

Just keep this formula in mind:

Value = Net Operating Income / Cap Rate

Make sure to factor in your operating costs including a potentially higher property tax rate. And when you solve for cap rate, if it’s much below 6% using the current lease revenue, I would be quite wary of the deal. I would not calculate using the new NOI unless you’re sure you can fill both spaces.  Good luck!

Carl Cheung · Answer

Thanks all.Yes I thought that the need to update it may be "built in" the $/sqft but seems that there needs to be additional accounting for that.

If I were the owner/operator, I would figure to move the business to a more visible location since I think that would have much more upside with bringing new clients in so I do need to take into account the need for updates/ability to lease to new tenants. Thanks again!

Bob Solak · Answer

With a long-empty upstairs office space and a first floor tenant whose lease will end within the year, I would be worried about finding a lender to agree to lend you the money without significant down payment.  And *usually* if you are after cash on cash return you will want as much leveraged as possible.

You have to decide whether this is an investment for cash flow or if you are going to own/operate, since as others have mentioned, that changes your calculations.

If cash flow is your game then you'll need to analyze the return on your investment that you'll need to make to modernize the spaces so that you can get the market rents that the brokers (but not potential renters apparently) think its worth.

But if it were me, I'd be worried about the current tenant not renewing and being left with a totally vacant building, with no cash flow, that needs significant updates to lease again.  You'd best reserve a fair amount of capital.

Paul Smythe · Answer

The building's value in the market is determined by the income it generates (with possible adjustments for potential future income on a fully occupied building, but that will take a buyer with higher risk tolerance). Your use as an owner operator matters for your situation, but it doesn't matter to the market unless you're doing a sale-leaseback.

It's all about the numbers. If the building needs to be updated, that should be factored into pricing. Lack of lease puts the risk on you to place a tenant.

The question is if you feel comfortable with the current tenant, current returns, and the risk/upside of the vacant space.

Good question on the broker. I think you're smart to be skeptical, I've had brokers push me to pursue properties that probably weren't going to be good investments. Doesn't sound like he's that far off on the valuations, but comps are not how this should be valued.

Trust your gut.

Carl Cheung · Answer

Thanks. How would that change if I were the owner/operator? I may possibly take over the business on the lower floor.

The current lease for the lower is about 48k annually and they are saying it's a 6 cap. Thanks.

How to properly value real estate and use a commercial broker

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