Unlike the way that a value or asking price for residential real estate is determined, the worth of a commercial property is based primarily off of one thing…NET OPERATING INCOME!
Residential Real Estate 101
Residential property will generally be valued using a comparison to other properties in the general vicinity.
Recent closed sales that occurred nearby the subject property are used with adjustments made for bells and whistles that might add value to the home in question (i.e. 5 bedrooms vs. 4 or a larger lot size) or negatives that may subtract value (i.e. original kitchen or bathrooms).
It is a process that would have to be termed an inexact science with the marketplace ultimately acting as the final arbiter.
Commercial Real Estate (CRE) 101
For valuing commercial real estate there are no premiums typically paid for curb appeal (although in actuality rents may be higher as a result potentially increasing the buildings gross income) or the number of bathrooms in the building.
Any premium a buyer is willing to pay for a given area will be reflected in the capitalization rate, basically the return for an investor, used to determine value. The more desirable an area is considered, the lower the cap rate a potential buyer will be willing to accept.
Buyers of commercial real estate are investors concerned with one thing, the return expected on their investment dollars! In other words the Net Operating Income (NOI) that a building throws off derived by subtracting building expenses from gross rents.
(Note: If two buildings in different locations have the same NOI, the one with the lower cap rate will have a greater value. To see for yourself divide a $100,000 NOI by .05 and .09 to see the difference.)
Back in 2014 in an article that asked whether prices for CRE may had gotten a bit too frothy (Cap Rates At Record Lows – Speculation or Prudent Investing?), the following explanation was provided…
‘In the world of commercial real estate the way that an investor, or buyer of property, will evaluate that investment is through the simple equation known as the capitalization rate.
Simply the capitalization rate, or cap rate as it is commonly known, is calculated by taking the Net Operating Income of a property (NOI) and dividing it by the price of the property.
Cap Rate = Net Operating Income/Price of the Property
As an example if the NOI is $24,000 and the asking price or recent sales price is $300,000, then the Cap Rate is 24,000/300,000 which equals .08 or 8%.
If an investor were to buy this building given the criteria above his return would be 8% and, if financing were to be used, the rule of thumb would be that the cost of funds or mortgage rate would be below 8%.
In some areas of the country today, however, this has not necessarily been the case.
Some investors, spurred on by the availability of easy money worldwide, have been willing to buy property with a cap rate as low as 0% under the investment thesis that the capital appreciation of the building would be significant…‘