HOW ARE COMMERCIAL PROPERTIES PRICED
When determining the value of the residential real estate, investors have a relatively easy time. “Comparable”, albeit we all know there are some adjustments that need to be made for location, age, and land square footage, but still a relatively simple formula.
Easier yet, go to Zillow. They know everything. (sarcasm)
Commercial properties can be valued by numerous methods.’
There are four distinct ways to determine the value of a commercial real estate asset
Gross rent multiplier
Similar to residential properties, commercial real estate may also be valued utilizing sales comps.
Comparable properties are similar assets that you can compare by:
Type of construction
Size (low-rise, mid-rise, high-rise) and or “class” of buildings.
When using this method, you’ll be comparing prices per square foot and adjusting the value based on various different aspects of each site. This is similar to residential real estate comparables. Price per Square Foot multiplied by Square Footage = Property Value
$100 / sq. ft. x 10,000 sq. ft. = $1,000,000
The sales comp method is most commonly used when an asset is largely or completely vacant, meaning the income (or lack thereof) adds little to no value to the property.
A buyer will typically look at this first, but it’s not likely to be the “primary” factor establishing value.
Commercial real estate investments are more often than not valued based on the amount of income that they produce i.e. rental income.
So, investors are essentially purchasing the stability of the cash flow of the asset.
A cap rate is the anticipated cash-on-cash return if the asset was purchased in all cash. All cash because all things need to be evaluated equally.
Annual Net Revenue divided by Total Purchase Price = Cap Rate
$100,000 per year divided by $1,000,000 purchase = 10% cap
So why do investors use cap rates?
Well, each investment group will have a different acquisition method.
Some investors may prefer all cash, some may prefer heavy debt, and others may only utilize light debt.
In each of these instances, the actual amount of cash flow to the investors will change depending on the aforementioned, however, the property still produces the same amount of annual income regardless.
Some investors will consider an asset based on a replacement cost.
This method is often used alongside the comparable method due to the fact they need to assess whether would it be better to buy this asset as is or build a new investment like this.
These buildings will often require some sort of renovation aspect, which will be included in that calculation. Older assets will likely need some renovation, also part of this equation.
In order to calculate this one must know the total cost of acquiring land and building a new property.
New Construction Costs minus (Acquisition Cost plus Renovations) = variance
$170 / sq. ft. minus ($80 / sq. ft. plus $25 / sq. ft.) = $65 / sq. ft. = delta.
This variant is intended to show the potential profit for the investor in this scenario.
If the variant is positive, an investor might decide to flip the property for a profit or rent it out at the current market rate. However, if the variance between the two numbers is negative, then you likely don’t have a deal at all, unless there are other determining factors.
THE GROSS RENT MULTIPLIER
The Gross Rent Multiplier (GRM) is another useful valuation assessment for determining a commercial property’s value.
The GRM is a ratio of the total price of the value divided by the gross revenues received from that property.
This number will tell you how many years it would take to pay off the property based on the gross rents received, so a lower number means the investment is a better opportunity.
Total Purchase Price divided by Gross Rents = Gross Rent Multiplier
$100,000 purchase price divided by $10,000 in rent = 10 GRM
At 10 GRM means it would take 10 years for the property to pay for itself based on the GRM.
If you want your property to pay for itself in 7 years, you would use a GRM of 7.
So, as the investor, you would take the gross revenues of the property you’re looking at and multiply that number by your gross rent multiplier of 7.
Using the example above, an investor would multiply the $10,000 in annual rent times 7 for a total investment value of $70,000.
Depending on the investors' objectives, that being different for most investors will apply a different GRM when looking at assets, so it’s not as commonly seen as cap rates or sales comps.
It's rather subjective and arguable for establishing a value.
I see CAP rates as likely being the choice for valuing a property unless it is a vacant asset.
There’s a lot to be said about the value of leases~ that is another chapter.