A Basic Primer in Valuation of Commercial Real Estate
I am asked occasionally how value is derived on a commercial property. Unlike single-family residential real estate a commercial property's value is driven by income: the more income creation of a commercial property investment the higher the value will be. Being that this is just a primer I will only be showing value by using the capitalization method of the investment. The capitalization rate or CAP rate of an investment is in direct proportion to the income generated by the investment. Here is the basic method of calculating the value of an investment using the CAP rate approach:
Potential Rental Income (both income from leases and market rent for vacant units)
Less Vacancies (8-10% of Potential Rental Income)
Equals Gross Operating Income
Gross Operating Income Less Operating Expenses (does not include debt service, commissions or reserves [be sure to include 6% or management fees even if you self manage])
Equals Net Operating Income (NOI)
NOI divided-by Capitalization (CAP) Rates for the area for specific type of property (for my area I see CAP rates between 5% to 9%)
If you adjust NOI up, Value goes up and inverse if NOI goes down.
If you adjust CAP rate higher, Value goes down as a higher CAP rate could potentially be viewed as a more volatile investment.
If you adjust CAP rate lower, Value goes up as a lower CAP rate could potentially be viewed as a stabilized investment.
There are more advanced tools used to further analyze a property such as IRR (Internal Rate of Return), which looks as cash flow over a set period of time. But I won't go into that here.
Let me know if you have any questions,