In our previous post, we discussed the steps needed before an evaluation. Today, we will discuss the evaluation process in a little more detail.
There is a significant difference between evaluating a residential house and assessing a commercial building. When listing a residential property, emotional factors are taken into consideration, whereas when assessing a commercial property more weight is given to hard numbers. Generally speaking, two factors play a crucial role in evaluating a commercial property: income and capital gain.
Two types of Economic Value
From a very broad perspective, commercial properties can be evaluated by taking into consideration two factors: net income and capital gain.
In addition to hard numbers (net income), the existing and future income potential of the property is considered. In the near term, income potential can be predicted through the change of use approvals by the local municipality. But it is quite challenging to predict the future potential of the property as it could depend on multiple factors such as economic growth and job creation, future development plans, etc. Again, assessing capital gain is a lot more complicated than it sounds, but suffice it to say that any potential property may have in the future is to be considered at the time of evaluating the property.
Net income refers to the overall income the property generates, considering both current net income and potential net income. Although there are discussions around the meaning of “net income”, “net net income” and “net net net income”, what it boils down to is that net income is the income a property generates after paying all its expenses such as property taxes, utilities, maintenance, etc. The net income is generally accounted for before paying debt (mortgage) and taxes (income tax).
Know the Cap Rate
There is another term you have to be familiar with in order to calculate the value of the property: Cap Rate. It is used in relation to net income to evaluate the property. Cap rates are determined by the current conditions of the market for the area in which the property is located, and the type of property it is. Although cap rates on a particular type of property may differ from area to area, usually cap rates are lower on apartment buildings and higher on office buildings. Remember that the higher the cap rate, the lower the price and vice versa. Cap rates can be as low as 3% and as high as 14%. This simply means that if you were to pay all cash for the property, you will get 3% or 14% on your money. For example, if you purchased property for $1 million and paid all cash, you would expect a return of $30,000 to $140,000 depending on multiple factors. These factors include property type, risks associated with the property, and the location of the property.
Here is the formula for calculating the value of a commercial property:
Value (Listing Price) = NOI (Net Operating Income) /Cap Rate
Apartment Building Net Operating Income: $100,000
Apartment Building Cap Rate in The Area: 5%
Value (Listing Price): $100,000 / 0.05 = $2,000,000
The same income with a 10% cap rate for an office building will give you a $1,000,000 listing price ($100,000 / 0.10). As you can see cap rates are a very important factor in your evaluations.
You can search current commercial listings and recently closed transactions to gauge the cap rates in your market. Further, you can find valuable information in research-based reports published by commercial real estate firms in the area.
Cap Rates and the location of the Property
Cap rates are specific to the location of the property and the property type. The risk is also a factor; for example, apartment buildings are considered to be lower-risk investments and office buildings are a higher risk. The location of property can be assessed as follows:
- Primary Market: properties in major urban centers and surrounding areas are considered primary markets and considered to be lower risk.
- Secondary Market: These are generally neighboring communities of major urban centers
- Third Tier: As the name suggests, these properties are outside the primary market and are considered to be a higher risk.
As you might have anticipated, the higher the risk the higher the cap rate, and the higher the cap rate the lower the value (listing price) of the property as illustrated above.
Different types of commercial properties and the risks associated with each type will influence your property evaluation. You have to understand different types of properties and their current demand in the market. Following are some of the most common types of commercial properties:
Mixed use: Usually this is a retail environment on the main level and offices or apartments on the upper level(s). These type of properties are harder to rent as there are much better options available for the tenants. There are exceptions to this general rule, especially new mixed developments.
Multi-Family: These are rental apartments ranging from a couple of storeys to high rises. In most markets, this is a lower-risk investment compared to other types of commercial properties.
- Strip Plaza: These are mostly one-level retail outlets with available parking. This type of property is highly dependent on population stability or growth in the surrounding area. New housing development is a good predictor of population growth.
- Retail: This type of property is generally owner-occupied and located in a prime location. Higher-net-worth areas and/or increases in family incomes are considered to influence the value of this type of property as higher incomes increase the purchasing power of residents in the area. Tenants thus pay higher rents.
- Office Building: Mostly occupied by professionals and corporations. In most markets, this type of property is considered to be one of riskiest, because a sudden economic downturn could lead to vacancies.
- Industrial: There are multiple categories of uses ranging from a factory to a warehouse. The current use that may potentially contaminate the property will negatively impact the value of the property. For example, an auto repair property use might be harder to finance and riskier for environmental assessment.
- Power Centers: In major urban centers this type of property rarely comes to market. You must work with a group of specialists to properly disclose all related matters.
Property Details to Consider for Finalizing the Listing Price
In addition to the important factors of location and type of property, the features of the property must be considered before setting a final listing price. Here is a breakdown of each type of property and feature that impact the value.
- For a Residential Investment Property consider:
- Proximity to amenities
- School district and ranking
- Rental demand
- Financing options available
- Residential Tenancies Act
For a Retail/Strip Plaza consider:
- Traffic count and flow
- Adequacy of parking
Office Building Price Will Be Affected By:
- Fiber-optic wiring
- Accessibility (public transportation and highways)
- Current rental vacancy
- Common areas and facilities
For Industrial Properties consider:
- Structural condition of the property
- Ceiling heights
- Loading docks
- Environmental assessment
- Proximity to transportation routes