You have probably noticed that people buy and sell homes (one of the most expensive investments they will ever make) with decisions based largely on emotion.
Sellers often ask more for their home because they overvalue the connection they have developed with the property. Buyers may be willing to pay more if they can envision their kids playing tag in the yard and family game night in the living room—or there is a detached in-law suite.
Of course, they are also highly contingent on the market conditions and the MLS.
Fortunately, commercial real estate investments are evaluated through a different, more logical lens. Hard-and-fast metrics exist to help ground both the buyer and the seller within a range of value.
Because commercial real estate values are mainly based on potential financial results, and metrics make those simple to benchmark, it can be easier to find a fair selling price. It is not foolproof; emotions do come up in the negotiation process. However, because there are established options for valuation, these transactions feel a lot less personal.
We have outlined some of the general methods of property value determination, so you can have more confidence when evaluating offerings and a greater understanding of the numbers you are looking at.
Because the point of owning investment real estate is to generate profit and property appreciation, most assets are valued based on cash flow.
The capitalization rate, or cap rate, is the way investors measure this profit. Although there are variations on the theme, the concept is simple. By dividing the annual net operating income (income minus expenses before debt service) by the purchase (or purchase plus renovation) price, an investor can determine the cap rate of the property.
Cap rates can also be used to estimate property values and to compare the income streams of commercial properties against one another. This method is similar to measuring a public company’s price to earnings (P/E ratio). If an investor knows the cap rates for similar properties, they can divide the net operating income by the cap rate to determine the property’s value.
But investors, please note that cap rates can be engineered to look exceptionally good if the operator includes overly optimistic income expectations or if the property valuation is artificially high. Talk to your sponsor about how cap rates were calculated in the offering document. If they compared cap rates of similar properties, ask which factors are driving the variations.
Unlike shares in the stock market, real estate assets are not traded frequently. There are no ticker symbols telling you the trade price either. And unfortunately, there is no MLS-style tool for commercial real estate.
But, by seeking similar property types, vintages, sizes, markets, and other variables, a potential commercial real estate buyer can deduce the price others were willing to pay for similar properties. Buyers typically need the help of brokers to access this type of recent data. From there, they can gauge a fair price for the property they are considering.
Often, a price per square foot or price per unit is used as a comparable ratio between two similar properties. Bear in mind that some give-and-take is necessary to understand why certain properties are more valuable than others. Those factors might include:
- Property type
- Property use
- Year of construction
- Square footage
All things considered, determining replacement cost value is simple. How much would it take to build this property today? Add up all the associated costs, including materials, labor, soft costs, and profits, to calculate it. Then compare that number to the asking price, using this figure to determine whether you’re overpaying for the property or taking on too much risk.
Developers will not go forward with a brand-new building project if the value of the as-completed property is not significantly above the cost of building the property (typically within a 20 to 25 percent premium range). Developers need to make a profit and have a cushion for the risk of undertaking the project over several years of unknown economic conditions.
Why is this important? Because it somewhat sets a ceiling for the purchase price of a property. Buyers of existing property typically try to stay under the replacement cost, including necessary upgrades. Generally, if you pay too much above the replacement value, you are putting yourself at a disadvantage. Others will start building new competitive properties, capturing some of your market share, and impeding on your building’s appreciation potential.
As an individual investor, one of the biggest challenges in valuing commercial real estate is tracking down the necessary data. Because information like comparable sales and cap rates can be so valuable, brokerage firms often keep this information private.
Investment groups have a better opportunity to collect data and to be well-informed about the market. If you decide to work with a syndicate, you can benefit from their networks and rely on their expertise to make the best possible decision.