Jun 17, 2013
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Analyzing Commercial Real Estate|Crucial to Successful Buying

To do a proper commercial real estate analysis, you must understand its market value. Long term successful investors make money when they buy, not just when they sell. You reduce risk and increase your chance for great returns when you buy properties at or (preferably) below their market values.

3 Techniques to Value Properties

Investors, lenders and appraisers rely on three techniques to value properties.

1. Cost approach:

  • Calculate how much it would cost to build a subject property at today’s prices;
  • Subtract accrued depreciation;
  • Add the depreciated cost figure to the current value of the lot.

2. Comparable sales approach:

  • Compare a subject property with other similar (comp) properties that have recently sold;
  • Adjust the prices for each positive or negative feature and/or differences of the comps relative to the subject property. Note:  It is best to have three or four properties to compare.

3. Income approach:

  • Estimate the rents you expect a property to produce;
  • Convert net rents after expenses (net operating income) into a capital (market) value amount. In other words you divide the net operating income of the property by a market cap rate for that particular type of product in the marketplace.

You evaluate a property from these three perspectives to check the value estimates of each against the others. Multiple estimates and techniques enhance the probability that your estimate reflects reality. If your three value estimates don’t reasonably match up, either your calculations err, the figures you’re working with are inaccurate, or the market is acting “crazy” and property prices are about to head up (or down).

3 Factors of Income Approach

Concerning commercial real estate analysis, the approach I put the most emphasis on is the Income approach. The three factors of the Income approach are Effective Gross Income, Operating Expenses, and Capitalization rates (Cap rates).

When looking at effective gross income and operating expenses, be careful that you’re looking at the actual numbers – not the “pro forma” numbers. Pro forma numbers are projections and you want to be dealing with actuals. Cap rates are derived from the comparable sales of comparable properties in the immediate market area and/or by the rate of return that you want on your money. If you talk about a 6 cap, then you are saying that you want a 6% return on the existing net operating income of the investment.

4 Things to Determine a Good Buy

When I analyze a property, I calculate the following four things to determine if I want to buy the property:

1.  Net operating income (NOI):   Net operating income = effective gross income – operating expenses.

2.  Annual cash flow:   Annual cash flow = net operating income – debt service

3.  Cash-on-cash return:   Cash-on-cash return = annual cash flow divided by down payment

4.  Cap rate:   Cap rate = net operating income divided by sales price

Other Important Factors

Also note that other important factors in your commercial real estate analysis are the use of/or zoning of the property, the location of the property, the credit worthiness of the tenant(s), the leases in place, the condition of the property, the contracts on the property and any possible environmental problems with the property.

1.  Use of/or zoning of the property – Make sure the current use matches the zoning of the property.

2.  Location of the property – Is it in a growth area, are there complimentary users around, is there easy ingress and egress, do the demographics match the use, what are the traffic counts around the site, what is the vacancy factor in the marketplace – These are all questions that verify a good or bad location for the property.

3.  The Lease(s) – Is it or are they NNN, NN, N, Gross, how much term left, if there isn’t much term left, what is the likelihood of renewal, are there any hidden Landlord costs, what is the entity on the lease and is it guaranteed, is it a standard lease for the marketplace or is it unusual for the area, is it assignable, does it have options, review all amendments – These are some of the things that you need to be reviewing in the lease to make sure you understand just what you are buying – Some people believe they are buying a building while others believe they are buying a lease or leases.

4.  Condition of the property – Do a thorough inspection of the property to include the roof, the mechanical systems, the structure, the electrical, the plumbing, the parking lot and all of its fixtures – Estimate the life span of each of these things and make sure that you put this into your financial picture of the property.

5.  Contracts on the property – Make sure that you review all existing contracts and the vendors so that you know your obligations and whether they go with the sale – These contracts are also an indication of whether the property has been consistently maintained – If there are no contracts, then you need to take this into consideration so that you can paint an accurate financial picture.

6.  Environmental – Are there any obvious environmental issues that need looking into and have there been any environmental notifications sent to the current owner or to any of the tenants – You should also check with the local environmental agency to not only learn about your building, but the area in general.

With careful analysis you can take away some of the risk when purchasing the property.

As I have said before, if you have any questions or I may be of assistance with your real estate questions please contact me. My way of giving back is to give away my knowledge. Thank you for reviewing this article.

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