How does one evaluate vacant commercial properties?

Question

Bill Gulley,

How does one go about evaluating a vacant commercial property?

Bill Gulley · Answer

Welcome to BP, Jason!

I'd say that's a first for a first post, directing the question at someone, thank you and well done, shows you are familiar with the BP site. :)

Commercial valuations are weighted toward the income approach over new construction with depreciation and the market sales approach, but the market sales may win out in some cases as the primary approach in some cases. An exception might be where there are very similar units, like a condo office park, past sales may be a better indicator, and if there are comparable properties outside that project as well. This is too, if the building is to be owner occupied, but there is still an income analysis as to the lease/own aspects and consideration if the property were to be leased.

But, for the most part we look at income derrived from the property.
This also assumes we are looking for a market value and not an investment value for certain investor. For that you would identify a "stabilized" income from the property. This is an average of income to be received over a period, with deductions for major repairs and other expenses taken out. The longer the economic period the more comprehensive the valuation can be and probably should include the future sale or disposable or even a salvage value being brought back the the present value together with the stream of income.

You will need to construct pro-forma statements building your best estimation of income and expenses for a vacant property where actual numbers may not be available. Similar projects can give good estmations for actual figures. You need to make calls, get bids, utilities can be found your insurance agent can give quotes, financing rates found, ect.

You basically construct an income statement identifying potential gross income, the effective gross income, expenses to arrive at a net operating income.

Not only do you consider income, but also the known or expected expenses and major improvements, those as capitalized and depreciated being brought back to a present value. Such future expenses may require a sinking fund or savings account that not only effects the use of funds but impacts the capitalization at differents times over the period.

Then you must select an appropriate capitalization rate. As to market value, the cap rate must be one that a reasonable and knowledgable buyer would expect for a similar investment given the required resources, risk, degree of administration and management for the alternative investments.

To arrive at an appropriate cap rate there are several methods. The summation or build-up method is begins by identifying another investment that carries zero or as close to zero risk as can be found and then building up the return that is reasonably expected with each additional risk identified. The identified risks will be different for different projects, for example a dry cleaners will have more risks than a store of equal size used for most retail ventures due to enviromental issues. Adjustments may be made for the investor's risk preferences and market perceptions. Each additional risk then adds to the cap rate required compensating for the additional risks assumed.

The band of investment method is appropriate when the capital structure includes various investors or financing sources. This is a weighted average of rates required by each investor or the weighted average of contributions to capital such as a first, second mortgage and cash injected into the project. This too is a weighted approach to find that return required various rates at different contribution levels.

Another technique is the comparison method. This is an evaluation to compare the project to the ideal investment. The ideal investment carries a reliable source of income, unlikely competition in the market, little governmental or functional restrictions, a very low management burden and stable demand as well as other factors. If an ideal investment requires a rate in the market, like 7% this becomes the ideal cap rate demanded or required. Then, as mentioned above in accessing the project risks and other factors like management, frequency of repairs or say collections the subject property is found to be 60% as desirable as the ideal investment, then 7% divided by 60% = 12% as an appropriate cap rate.

An overall capitalization rate is another approach and mostly used for smaller commercial properties. These rate are taken from the market on past sales where the net operating income is divided by the sale price to find the market cap rate. There may be 5 or more examples or comparables used and then an average rate is identified, but then that rate may be adjusted for any significant differences, like location. Unlike the market approach to value where the subject property is never adjusted, in finding the cap rate, the beneficial aspects (or detriments) may be considered in selecting the most appropriate cap rate.

There are many other factors as well, but this should get you started. The appropriate cap rate is then used over the expected period of income to arrive at the valuation.

Many of the same factors are considered in finding a specific investor's cap rate. There are economic factors as well as financial aspects to selecting the required yield of a certain investor. Thier cost of capital and opportunity costs must be considered.

Excess land or other improvements may be better evaluated by the market approach and construction approach, weighted in light of the subject to significance. For example, if a property includes 25,000 sq ft of unimproved land, that may be divided off from the subject project and assessed more from the market approach. If there is a storage building, or perhaps a unique storage system pole barn used at lumber yards to stack materials, concrete oil pits or a communications tower fixed to the property then the construction or replacement approach would be favored for those improvements. Then those valuations can be adopted into the overall valuation.

Lastly, saying commercial cuts a large swath, the method selected needs to be appropriate to the type of property. The capitalization of an industrial plant won't be the same for a car dealership or retail, an agricultural business is much different than just accessing raw land or residential lots. Apartments are different than recreational properties or motels. Each carry unique risks within each category for the owner or investor so in commercial, you really need to understand the industry and category of the property to evaluate the risks and returns expected. Good luck!!!   :)

Oren K. · Answer

First evaluate how deep your pockets are :).

Vacant commercial property is vacant for a reason. Filling it up is no simple fast process unless you have a tenant in your back pocket or are going to occupy it yourself.

More seriously, make sure you have a VERY clear understanding of demand for that type of space (office, retail, industrial, warehouse?) in the local market. It may be sitting empty for a long time and you have to carry the operating costs (e.g. Taxes, Insurance, some utilities, Security, etc.). Also plan on having to provide tenant inducements (TI) when you finally get a tenant unless there is high demand (but then it would not be empty!).

You will also run into insurance issues since it is vacant. And don't forget financing (if you need it) is going to be more challenging. Lenders are going to be looking almost exclusively at your other cash flow and assets to provide their security.

Eric K. · Answer

Jason Jenkins

Can you tell us a little more about what kind of property you are considering, plus what your goal is with the property?

One way to look at commercial is to think of it as buying a lease, not a building.  You're buying the income stream which is created by a lease.

You can estimate that by looking at what similar properties in your area are leasing for, then apply that to your building.  You have to compare your building with the others and adjust the price up or down.  From there you can estimate how much cash your building will generate.

Remember that the CAP rate is a "going in" rate, which means it's only for the cash the property is generating today.  If you have weak leases, like ones that expire in the next 12 months, then your CAP rate isn't telling you much.  It can change from year to year and tenant to tenant so think of it as a snapshot in time.  You need to look at IRR (internal rate of return) which measures the investment over the life of the holding period.  You can find quite a lot of info about IRR on the internet, including YouTube.  There are also more complicated measurements like FMRR and MIRR.  Excel has a function for that as well.

Like Bill said, CAP is a measurement of risk.  You estimate the cash flows, apply a CAP rate, then value the building.  In that order.

You can use sale comps to check the price of similar buildings, but in the end you are buying the cash flow for an investment property that you will rent out.  Comps can help you get a feeling for what other buildings are selling for.

If your building is vacant then be prepared to use a lot of cash in the first year, even take a loss.  You will have to pay taxes and insurance, plus there will be costs when you find a new tenant like leasing commissions and tenant improvements.  So don't make too much of a stretch on a vacant building unless you have the cash for a cushion.

And in the end, use a Buyer's agent.  There's no reason not to.  You will learn a ton just having conversations.

Bill Gulley · Answer

Yes, that's correct and it's built into the method described above, as mentioned.

Valuation is not 100% off of income streams, it depends on the highest and best use of a buyer, commercial is far beyond leasing space or apts. The key is....the appropriate CAP rate method used.

I doubt any 100M deal is based on arbitrary rates, they probably didn't know or didn't want to try to explain how the required returns were determined. :)

Roger Doe · Answer

Hello.  I am new to the forum but noticed your explanation on valuation and I'm interested in your discussion.  I am an experienced real estate investor.

Do you guys have a systematic method for calculating cap rates because I can't seem to find anything.  For example, with stocks, analysts have used CAPM (although it's popularity is dwindling) which uses volatility to be a proxy for risk.  Although I have a problem using daily stock price as a true measure of volatility, at least daily price fluctuations is something resembling volatility.  We don't seem to have anything similar for real estate.

I have friend at Blackstone that does 100+ MM development deals.  And, I've asked him what they do.  They use hurdle rates that they simply arbitrarily assign to specific types of developments.  If a development exceeds it, they do it.  Seems pretty lacking.

Can you share exactly how you come up with your cap rates?  Do you have a data-based process in which a cap rates is derived?

Bryan Hancock · Answer

How one differentiates oneself has more to do with their ability to raise and organize capital in my experience than it does to outguess other people's financial models.  The impact of the exit capitalization rate also diminishes if one holds the project for an extended period of time.

Investing has more to do with instincts and one's ability to create value than it does with precisely calibrating exit capitalization rates and/or any of the other interim cash flows.  If you simply use a WACC calculation based on YOUR borrowing capacity (loan constant) and how hard YOUR equity needs to work then things should be just fine.  If others bid more or less that is their prerogative.  The best investors aren't bidding against many others and deals are presented ONLY to them.  Thus the CAPM concepts of efficient markets are fundamentally inconsequential.  These are the folks that produce outsized returns for their investors and are able to attract capital to fund growth.

How one underwrites an investment has a lot to do with how their capital is organized, their tolerance for risk, etc.  Any attempt to make a mechanical procedure that is one-size-fits-all would be an exercise in futility.  The perceived risk of an investment will necessarily vary by investor and thus their WACC and bid price will be different.

Jason Jenkins · Answer

Eric K.

Thanks for that response. I'm very familiar with the information you provided. It was definitely a relevant reinforcement of the principle information I've gathered over the years. What you did catch me off guard with was your FMRR equation. I had to go and look into it further. It took me exactly where I wanted to go. And that was an absolutely great addition to my original post. Thank you.

Ethan Vegas · Answer

Wow Bill, great info on cap rate methodology....thanks for the expertise!

Oren K. · Answer

Gentlemen,

Wonderful discussion with well articulated viewpoints.

As much as I am also a math guy and build spreadsheet to help with the analysis, I have to side with Eric K. on this, that it is as much about guts as it is numbers. You can also, usually (within limits) find / construct facts to support an opinion.

The market place is about decision making with imperfect information. When one person has a opinion / vision (the opinion / vision is treated as a fact) that is not shared by others or becomes aware of a change in 'facts' before others (in the stock market, this is called insider information ;), they can step in at the current market price and make a profit (either up or down).

If things could be 'system-ized' to the degree that Roger Doe is seeking, there would be very little volatility as everyone would be using the same method to determine 'value'. It would still be true that the creative person could create 'value' by seeing different possibilities but again, it is a change in 'facts' (the vision of a possibility) that would the drive the change in value; Different inputs, different outputs (or as some would say: Garbage In, Garbage Out).

Also, with respect to the tax appeal analogy / example; using any probability of success only applies if there is a significant number of similar appeals. This is basic probabilistic decision tree analysis. Over time, you learn how successful (and to what degree) appeals are successful and feed that back into the model so it becomes a better predictor of outcomes. You would also 'tune' your appeal to the most successful argument / strategy to increase your likelihood of success. Modeling a single event with out any history in this context is of little value and very arbitrary.

Oren

Eric K. · Answer

Roger Doe

Roger, for the technical jargon I was talking about definitions like this for determining the discount rate:

"ß - Beta - This measures how much a company's share price moves against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold mining company), which means the share price moves in the opposite direction to the broader market."

Language like that is more suited for a large company and can often be difficult for a small investor to apply to his situation.  A much easier explanation is to say, "the discount rate = the cost of capital."  Most people will end up somewhere between those definitions.

I'm all for creating systems since I am a "system guy" :).  There's software called ARGUS that is the gold standard for most real estate evaluations.  When I enter future assumptions it really is opinion.  I have to guess how much time it will take to lease space, how large those leases will be (square feet), how long the leases will be for, the probability of renewal by existing and future tenants, how much they will pay, what the inflation rate will be in 10 years, etc.  Predicting how much a tenant will pay, how much in tenant improvements will be needed, and how long the space will stay vacant before finding that new tenant is speculation when you're talking about a lease that won't be signed until 2020.

I know a guy who owns part or all of about 90 retail projects.  The thing you will most often hear him say before buying a project is, "Can I fix this?"  His gut instinct is the the most important calculation he has.

How does one evaluate vacant commercial properties?

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