I am enrolled in Coldwell Banker Commercial’s National “Emerging Broker Training” Program and it lasts for 100 days. After the initial startup phase, we were tasked with bi-weekly Web based conferences with each one concluding with a field work assignment.
Our current project is titled Underwriting. At first glance, this may seem like a banking term, but in commercial real estate, this is the process we use for determining a value of a property. For the purposes of this article, I will focus on income producing commercial properties. We start with the rental income a property will produce in a year. Vacancies are factored in usually at a rate of 10% for an average market and that gives us an adjusted gross income for the year. We then calculate expenses that include Taxes, Insurance, Trash Removal, Common utilities, Repairs, Professional Services and other expenses associated with owning an investment real estate property. Once Expenses are subtracted from our gross revenue, we arrive at the net operating income, commonly referred to as the NOI.
The next part of the process involves applying internal market knowledge and assessing an appropriate Capitalization Rate (CAP rate). This reflects how strong your market is, the financial strength of the tenant(s) and what the demand for your type property may be. Let me give you a quick example. If a current property has a net operating income of $100,000 per year and sells at a 10 CAP rate, the sales price would be $1,000,000. $100,000/.10 = $1,000,000. That same property selling at a 12 CAP rate would be valued at $833,333. $100,000/.12 =$833,333. Income producing properties that have corporately guaranteed leases are currently selling at 4-6.5% CAP rates while other properties that have lessor strength tenants may range from 8-12.
This brings about an important point for those of you wanting to sell property. Income producing property sells best when the Incomes are high, good tenants are in place and the expenses are in check. Cutting down on vacancies in a desirable area can be as simple as outperforming your competition. Are your units clean and ready to occupy? Have there been some recent updates to kitchens and bathrooms? Is the management friendly and professional? Many sellers don’t take the time to tighten up these areas prior to taking a property to market. If we can cut our vacancy rate from 10% to 5%, that additional income can add serious value to our bottom line.
What about expenses? Management expenses can typically account for 6%-10% of a budget. Using a professional manager may be expected for certain properties and not the right place to save money, but what about services? Are you getting the best deal on trash removal? Are common lights on timers to avoid high electrical bills? Are you paying what you should for accounting and legal advice? Are you keeping the property well maintained to avoid expensive repairs? Are you able to self-perform certain tasks like lawn care of landscaping?
Take our example from above and imagine lowering both vacancies and expenses so that the NOI improved by $10,000. Using a 10 CAP, this adds $100,000 to the value of the property. Many sellers want to evaluate their property on the best-case scenarios and take it to market without taking the necessary steps to make it sellable. This results in negotiated pricing and longer market time. Take the time to properly present your property before you put it up for sale. The numbers in commercial real estate don’t lie and sophisticated buyers are savvy to the process.