When a commercial property is for sale, you will want to determine the value to see if the list price is accurate. It’s important to not assume that the list price is the value of the property. Here are the steps to figure out commercial property values using the capitalization rate method.
How to Determine Commercial Property Values
The value of any commercial real estate is based on the amount of net operating income the property creates each year.
Each additional dollar of annual income increases the value of the property by roughly ten dollars, depending on where the property is located, and the age of the property. This extra net income can come from either receiving additional revenue in rents, or from reducing expenses by managing the property more efficiently.
How to Determine Income and Expenses for a Commercial Property
You will want to look at a rent roll to determine the income of a commercial property. The rent roll is a list of the rental income for each unit such as an apartment, self storage unit, mobile home lot or office. Be sure to look at the rent roll and not the pro-forma rent roll. The reason is that a pro-forma rent roll shows an expectation of the rent in future years and not the current rent.
Common commercial real estate expenses include real estate and personal property taxes, property insurance, commercial mortgage, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.). You will want to consider the age of the property and consider any unexpected expenses you may incur with maintenance.
Keep in mind that you are trying to determine the actual amount it will cost you to operate the property, and not the seller’s current expenses. An owner may try to emphasize the income generated and minimize the operating costs involved in order to sell the property. They may also have unnecessary expenses that you would cut if you were the owner of the property.
Once you have identified the income and expenses and calculated a number for net operating income, you will want to look at the capitalization rate.
A capitalization rate or “cap rate” is the ratio of Net Operating Income (NOI) to property asset value. For example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
The final step of the process is to divide the net operating income by the cap rate.
Don’t Skip This Process when Buying a Property
Since buying commercial real estate is a large investment, it is important to not overlook this step when you are buying a property. If you assume that the list price is the value of the property, you may overlook a property that you deem too expensive or overpay for a property. By spending time to go through the process of calculating commercial property values, you will ensure that you have the accurate information to make an informed investment decision.