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[Please note … this report is only an introduction to the basics of Commercial Property Valuation. Mastering the concepts presented here will give you the ability to understand the components of Value in a specific property and speak with comprehension to Brokers, Sellers, Lenders and other investors. The art and science of complete property analysis is taught in additional courses available at our website]

If you are new to Commercial Real Estate one of the most important concepts to learn is how to determine the value of a commercial property. Just like Warren Buffet's quote above there is often a large difference between price and value in Commercial Property. Your goal is to always pay a price that is reasonable for the amount of value in the property you acquire.

If you are experienced in Residential Real Estate, it's time to start over...

Commercial Real Estate values have nothing to do with appraisals and little to do with comparables or “comps” in the traditional “residential real estate sense”. Commercial Real Estate value is determined much more clinically and that is what makes it so much easier to understand.

Much of the value of Residential Real Estate is determined by the emotions of the buyer, the supply and demand of that type of home and the desirability of the neighborhood. These are all very subjective ... so looking at comparable sales – that is, what similar houses in similar neighborhoods have recently sold for – is a time honored way to learn what you will likely pay for that Residential Property. And when you do get an appraisal they will use “comps” as one of the methods of determining value.

Once you have purchased a Residential Property, your job is very simple ... keep it rented and hold on and hope for general market appreciation. From 2002 to 2005 that was a great way to make money in most every market in the USA. Not so in 2007.

How is Commercial different ...

You will find that Commercial Real Estate value is based on numbers and calculations you will learn in this article. Commercial Property values are much less subjective and much more focused on the Income the property will produce and the cost you will have to pay to keep that income stream coming. Before we get to the numbers, please remember this ...

You are Buying a Business

With Commercial Real Estate, you aren't buying a property so much as buying an actual business. You are buying both the physical property AND the income stream associated with the building. The income stream is a result the desirability of the product and/or service that is housed in the property.

In order to profit in Commercial Real Estate, you have to purchase the physical property at a reasonable price AND manage the business effectively.

In Multifamily Property:

The business you are buying is the provision of affordable, safe, clean housing reasonably close to jobs, schools and shopping with a responsive staff of management and maintenance people. Once you purchase the property, if your Multifamily Property cannot continue to provide that product/service at competitive rates, you have to question its value.

In Retail Property:

You are actually buying two layers of business. YOUR business is providing visible, attractive, well maintained space for retail tenants. And the profitability of your business is also dependent on your tenant's business strength.

Example: Compare two retail strips in the same town. They are identical in size and both listed by Commercial Real Estate Brokers at the same time.

The tenants in strip #1 are “Happy Nail Salon”, a massage therapist, a dog grooming business and a Subway store. All but the Subway store are on one year leases.

The tenants in strip #2 are Starbucks, a Verizon store, a title company and a Chiropractor. Starbucks and Verizon are on 10 year leases and the remaining tenants on five year leases.

You can immediately see the difference in value between the two properties. Both are Retail investment properties; however the difference in value is in the quality of the Tenant's Businesses and the length of the leases.

In Office Property:

Your business is providing well located, clean office space with up-to-date amenities and services – such as onsite generators, or phone and computer network cabling. Value is also dependent on your tenant's business strength.

In Industrial Property:

Your business is providing a building that meets the industrial requirements of your tenant(s). Value is also dependent on your tenant's business strength.

Now that you can see the dual nature of a Commercial Property purchase – the physical buildings and the business inherent to them, we can start to get down to cold hard numbers. The most important number to understand is the income the property produces.

In Commercial Real Estate, VALUE and PRICE are closely tied to INCOME no matter what property type you are looking for. There are other factors to take into account, which we go in to later in this report, and Income is a key determinant of value.

Before we dive into the hard numbers of property valuation there are some terms, abbreviations and simple formulas to learn. No heavy lifting here. Fortunately you learned all the math you need for Commercial Real Estate Investing in Grade School.

Commercial Real Estate Valuation Terms and Formulas

“Net Operating Income” - N.O.I.

The Net Operating Income is all of the income from the property minus all of the expenses EXCEPT FOR the payment of the mortgage(s) or loan(s) on the property and non-recurring Capital Expenses. NOI is an annual figure. Because the loan payment is not subtracted, you may hear the Net Operating Income referred to as the “Net Before Debt”

“Capitalization Rate” – CAP Rate

CAP Rate is a measurement of the profitability of a property. It is defined by the following formula

CAP Rate = NOI / Price

Examples:

1) A property which produces $100,000 NOI which is priced at $1,000,000 would have a CAP Rate of $100,000 / $1,000,000 = 10%.

2) If you paid $1,500,000 for the same property producing the same $100,000 in annual NOI the CAP Rate would $100,000 / $1,500,000 = 6.6%

As you can see, the more you pay for a given income stream, the lower the property's CAP Rate falls. For this reason CAP Rates are usually lower and Prices usually higher for properties perceived as higher quality or safety.

A brand new fully rented up property in a nice part of a growing town would command the highest price for each dollar of income produced and therefore, the lowest CAP Rate.

Price = NOI / CAP Rate

NOI = (CAP Rate) X (Price)

Market CAP Rates can be used to compare the property you are evaluating to others that have recently sold in your market. This is the closest you will get to a “Comp” in Commercial Property. Remember the “Average CAP Rate” you are given by the broker must be for properties that are actually comparable to the one you are evaluating.

The market CAP will help give you an approximate value for the property you are buying based on its NOI.

“Cash on Cash Return”

Cash on Cash Return is one of many measures of Return on Investment (ROI).

It is the annual return you would receive on the actual Cash invested in a property. It also has a simple formula.

Notice here we are talking about Profit, not Net Operating Income.

Profit is the income remaining after ALL expenses of the property are paid INCLUDING the mortgage(s) and loan(s).

A large NOI is a good thing, however if it does not translate into a good Cash on Cash Return, the investment does not make sense.

This is an incredibly important term to recognize and understand when researching properties. Here is its definition:

“Description of financial statements that have one or more assumptions or hypothetical conditions built into the data”

As you can see above the Net Operating Income is the single most important number in determining property value. It is actually the result of a rather detailed calculation.

NOI = (All Income) minus (All Expenses except Mortgage and non-recurring, capital expenses)

The biggest question in figuring the price of any property is this,

As you project the future performance of properties you are researching you will need to make your own assumptions and hypotheses based on Actual Data you get from your seller. This is an Investor's Pro Forma. You are trying to be as accurate as possible to make a purchase decision.

Make sure that any time you are projecting future performance of a property you are using realistic assumptions based on ACTUAL data from the seller.

Points to Remember …

· Investors make property purchase decisions based on Return On Investment (ROI), not NOI or CAP Rates. Always calculate your ROI … Cash on Cash return is a good method to use.

· Calculate and double check all numbers in the calculation of NOI for every property you research.

· NEVER trust any number in a Broker's Proforma.

· Always ask for Actual Numbers from the property. Request at least last year's and year to date profit and loss statements.

· CAP Rates can be artificially depressed in an underperforming property. Don't pass on a property with a low CAP Rate - believing it to be over priced. If there is a correctable reason the NOI is currently lower than expected. You can fix that problem and produce dramatic profits.

Now that you have some basic terms down….

Let's Go a Little Deeper

Many commercial real estate investment trainers will tell you that the Net Operating Income is the ONLY factor in the value of a piece of Commercial Real Estate. Here at Investortours University our $100M in Commercial Property experience has taught us that the Net Operating Income cannot be the ONLY measure of a property's value and here is why...

Your property has an Income Stream - the Net Operating Income

AND that income stream is produced in CONTEXT or framework

The value of your property is in the NOI AND the CONTEXT where the building resides. The context is all the surrounding market forces and local influences that can affect the value of that income stream.

This property is for sale with a CAP Rate of 11%.

This property is for sale with a CAP Rate of 4.5%

Which is the better prospect?

I know it is a lot like comparing Apples and Oranges AND you get an instant appreciation for the concept that Net Operating Income is NOT the only indicator of value in Commercial Real Estate.

Building #2 has the same $500,000 per year net operating income however it sits in a completely different CONTEXT.

It's only by acknowledging this difference in CONTEXT - all of the outside influences on the true value of the property's income stream - that we can make a valid evaluation of the property's value.

These outside influences include...

• The Phase of the larger Market Cycle
• The projections of population and job growth for the area
• The physical attributes of the building
• The age of the building and its maintenance
• The quality of the tenants
• The local laws, taxes, and neighborhood conditions that are surrounding the property
• Local weather patterns and most common weather damages

It's only when we take all of these context factors into account that we can truly place a value on that income stream.

The Value of a property is actually determined by three things

• Current and Future Income

• Reliability of Future Income

• The Risk Associated With the Investment

Only current income is expressed in NOI. The Reliability of the income stream and the Risk are all associated with the Context in which we find this building.

Because the negative effects of the larger Context can completely eliminate your profit it is equally important to evaluate Context as it is to evaluate an individual building.

Let's take each of the above components of Value one at a time and show why the current NOI simply cannot be the sole determinant of Value.

What if:

Your property is in Jacksonville, FL and a hurricane comes through

Your property is in NY and the state raises property taxes by 10%

Your property is in a smaller town and the major employer closes its doors

Your property is located in a town whose employers are dominated by industries that are rapidly moving overseas because of lower costs?

Is it an older building with foundation issues?

What is the neighborhood like? Is it declining?

• Future Income
• Reliability of Income
• Risk

You have to know the Market where the property is located to this level of detail to make an informed decision about the CONTEXT of an individual investment. A simple calculation of the current NOI is not enough.

One Last Thing….

Watch out for this common Investor Mistake.

Another type of comp quoted by most Commercial Real Estate Brokers is based on Price Per Unit (Multifamily) or Price Per Square Foot in other Commercial Asset Types. This type of Comp is very close to the Comps you would use in Residential Property Investment.

These Comps can be a good comparison with other properties of similar quality and location. Use them ONLY to make sure you are not paying too much for the property based on its Asset Class and quality

Here's how buying on Broker Comps can burn you…

A common investor mistake is buying a property at a “seemingly” good price for its Income, but paying too much for the quality of the buildings. If the property's income drops you will can end up owning a building that is now worth less than when you bought it.

When you buy you must simultaneously consider the Current Income, Future Income and its Reliability and Risk. Overpaying for an older property based on per unit or per square foot comps will dramatically increase your Risk over time.

If this all seems a little complicated … it is. Commercial Property Investment has a number of moving parts. Fortunately you don't have to be the one doing all the work here.

Commercial Real Estate is most definitely a Team Sport. You can't know everything about a particular market or property, BUT your Team of

• Real Estate Broker
• Property Manager
• Real Estate Lawyer
• Escrow/Title
• Commercial Mortgage Broker
• Field Partner

Sure can.

To help you pick the right markets and actually build a team to invest … even if that means going out of state … we have created a detailed course on Market Cycles, local Market Research and building a quality Team to invest in the best markets nationwide.

Check out our CD / Workbook Training Course

Double Your Profits by Investing Across State Lines:

The 5-Step System to

· Locate,

· Research

· And Successfully Invest in

The hottest markets in the Nation - even if they are outside the state where you live.

This is real world experience put into a format you can use right away.

And this is just the beginning ….

To your investing success,

Monte & Dike

Investortours University

http://www.investortours.com/

1-800-928-6033

support@investortours.com