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Commercial Property Valuation

By Rick Longpre on Oct 08, 2013 at 02:32 PM in Investing in Commercial Real Estate, Santa Barabara Commercial Real Estate

The most common client question is how to establish “market value,” either as a buyer or seller.  Commercial properties are not that different from residential properties in that comparable sales are critical to any fair market evaluation.  While similarities between commercial properties tend to be less than residential properties, they also tend to lack the emotional factor of residential sales.  Nevertheless, the process is similar and possibly more objective on the commercial side since the ultimate purpose of an investment in commercial property is to generate a future stream of income and thus the valuation metrics are more quantitative.

Comparable Sales Comparable sales sound easy enough, except it begs the question of how do you actually make the comparison between different properties.  It is rare to find another property of the same type, size, condition, age, etc., within the same market which also recently sold, to be used as a comparable.  Thus, what really is being compared are the various valuation metrics in addition to the physical characteristics of the property.  

Cap (or capitalization) Rate One of the most common ways to compare “apples to apples” is to compare the “cap rates” of different properties.  Commercial property investments are entered into to obtain a future value: either a stable stream of future cash flows or appreciation or both.  The initial annual percentage return on an unleveraged investment is the “cap rate” of that property.  Several technical terms must be defined in order to understand and utilize cap rates (as well as some related terms).

Gross Revenue, Gross Rental Income (GRI) or Gross Income = Total income generated by the property
Operating Expenses = the recurring expenses incurred in operating the property, excluding debt service (interest or principle)
Net Operating Income (NOI) = Gross Revenue – Operating Expenses
Net Income = Net Operating Income – Interest Expense
Cash Flow = Net Operating Income – Debt Service (principle & interest)
Cap Rate = NOI / Purchase Price (total investment since no debt is assumed)

Example:
Purchase Price = $1,000.000
NOI = $70,000
Cap Rate = 7.00% (70,000/1,000,000) 

Therefore a property with a higher cap rate is expected to provide a higher unleveraged return for the invested dollars.  Cap rates take into account many economic factors and projections, a topic best left to future posts. Do Cap Rates Increase As Interest Rates Increase? View this file for more background.

Watch for future posts on other valuation metrics including price/sfprice/unitGross Rent Multiplier (GRM) and more!