Back to the Basics

For those of you who are lost from the last post, in this blog post I will try to provide a few basic principles for commercial real estate.

First, let me say that there is a large amount of logic used in real estate. So if you believe yourself to be fairly logical then you may find great joy in commercial real estate. If that’s the case, give me a call sometime.

Okay, back to the task at hand. Let’s relate to what most already know: residential real estate.

If three houses are built adjacent to one another, and all have the exact same floorplan, the same finish out (tile, textured walls, countertops, fictures, etc), same size, and finally, the same use/utility (as a home). Said another way, all three homes were exactly the same in every facet, except one was built in 2005, one in 2010, and one in 2015. Assuming the market valued newer homes more than older, which do you believe would be more valuable?

If you said 2015, then you would be correct. Commercial properties are valued similarly, but with a strong focus on choosing Sale Comparables with a similar utility or use as the property being appraised.

So what happens when the Sale Comp is leased? The buyer purchased the rights to the income from the lease versus the rights to use the space/building. This is where commercial real estate departs from residential. The rent that the property is able to achieve less a market vacancy for the turnover of tenants and various expenses to the real estate provides what is called the Net Operating Income. This income is then capitalized into a value for the property with a capitalization, or cap rate. Cap rates are a form of a rate of return.

The cap rate is acquired through sales of similar properties which also had leases in place at the time of sale, and were purchased as an investment. The formula for attaining such rate is the Net Operating Income of Comparable/Sales Price of Comparable = Cap Rate.

There are also a few other techniques to use as a gauge or benchmark, such as Investor Surveys and the Band of Investment technique.

The expenses that are removed from the rent include, the real estate taxes, property insurance, property maintenance, property management, cleaning, grounds/landscaping, and others. These are typical expenses that allow the real estate to operate. This does not include capital expenditures, or cap-ex, such as roof or HVAC replacement.

Once a cap rate conclusion is made, it is applied to the projected Net Operating Income, or NOI as such:

Projected NOI/Cap Rate Conclusion = Opinion of Market Value

The Sales Comparison Approach and the Income Approach are reconciled into an appraiser’s opinion of value. What I have just described is a very broad and general explanation as valuation can get complex, or “hairy” as most appraisers describe it, very quickly. If you have questions, feel free to leave a comment below.