Valuations of Commercial Real Estate Properties

Analyzing a commercial real estate deal is different than analyzing a residential deal. While residential properties are largely valued based on comparative properties - with similar square footage, bedroom and bathroom count, and similar amenities - commercial properties are largely valued based on the income they produce. Below is a summary of the steps required to analyze a commercial property:

Identify the gross income

Identify the unit mix and current, and projected market, rent. Use this information to calculate a current and pro forma gross income. While you may not want to purchase a property based exclusively on pro forma income, it is important to understand what value may be added, whether through income increases or otherwise.

Calculate expenses

Identify the current expenses and project pro forma expenses. You can project pro forma expenses by referencing the current expenses, comparing those expenses to market and industry expenses, and comparing those expenses to expenses unique to you. For example, the owner may be paying 10% for property management, but you know your property management expense will decrease because, not only is market property management 8%, but you have a relationship with a property manager where you are charged 7%.

Vacancy

Identify the current and pro forma vacancy. Similar to the above, compare current vacancy against market vacancy trends. Do consider that vacancy may increase as you seek to increase rents.

Calculate the Net Operating Income

Calculate the net operating income by subtracting the gross income from the gross expenses.

Apply a Market Cap Rate to the Net Operating Income

Identify the market cap rate in your market. This can be accomplished through discussions with brokers, lenders, and fellow investors, and also by leveraging your prior experience. After identifying the market cap, divide that cap rate by the net operating income to calculate the value of the property.

It is valuable to understand both the current value of a commercial property, and the pro forma value of a commercial property.

Understanding how to properly value a commercial property is key. Wise minds have posited that “you make money on the buy” so understanding commercial valuations will help ensure that you do not overpay for a property. Conversely, understanding commercial valuations will also ensure that you do not pass on solid commercial deals. How else do you analyze commercial real estate properties?