Running the Numbers on Apartment Buildings and other Commercial Real Estate
Trying to figure out how much an apartment building or other commercial property is worth? Then follow these steps to find out the value of commercial property.
At its simplest, commercial real estate is valued based on a multiple of its income. The more income it produces, the higher its value. Unlike single-family houses, you can actually control the value of your apartment building: Buy one at a fair market price, raise the rents, and reduce some of the expenses, and you've increased the building’s income and, with it, its value. Amazing.
Tap below for calculators & formulas to help you run all the numbers.
Here’s How to Estimate the Value of Commercial Real Estate
You need to know two things to value commercial properties.
- The Net Operating Income (or “NOI”) and its
- Capitalization (or “cap”) rate.
Once you know both of these, to determine a building’s fair market value, you divide the NOI by the cap rate:
For example, if the building is producing $50,000 per year in Net Operating Income, and the typical cap rate for buildings in the area is 8%, then the fair market value of the building is $625,000:
So far, pretty simple, huh?
But how do you get the NOI and the cap rate? OK, stick with us, and we'll show you how.
The NOI is the income after all expenses but before debt service (i.e. the mortgage payment).
The cap rate is the rate of return if you were to buy the building 100% in cash. You probably wouldn't do that, but this is the standard way to measure the returns and value of a building.
The importance of the cap rate is that it gives us an indication of what investors are willing to pay for similar buildings in the same area.
If the prevailing cap rate for apartment buildings in an area is 6% (fairly low), that means that investors are willing to settle for a lower return, probably because the area and/or the building itself is very nice, easy to take care of, and has high-quality tenants.
If the prevailing cap rate is higher, say 10%, then that means that investors are looking for higher returns, probably because the area or building is a bit rougher and harder to manage.
How Do You Determine the Cap Rate?
The cap rate can be assessed by evaluating other deals for similar buildings in the same area. You would look at the NOI of comparable sales and divide it by the sales price to get the cap rate. The more comps you have, the more accurate the cap rate.
Typically, you don’t have access to that kind of data, but brokers do. So it makes sense that a great way to get the cap rate for an area is to ask several commercial real estate brokers. They should be able to tell you. Another good source is appraisers, whose business it is to value commercial real estate every day.
In other words, the cap rate is a few phone calls away.
The Fair Market Value of Commercial Real Estate
OK, now that you have the cap rate for an area, all you need is the financials of a deal from your broker. To get the fair market value, you apply our formula…
…and that's it!
The Bottom Line in Estimating the Value of Commercial Property
Commercial real estate is fairly easy to value if you know the prevailing Cap Rate and the Net Operating Income.
One word of caution: make sure the NOI is accurate and conservative. Many brokers over-report the NOI to make the numbers look good, and this will result in an inflated price. So make sure you examine NOI closely!
CLICK HERE to tap into the expertise of fellow investors inside the Connected Investors Forum.
When you’ve got a commercial or residential investment property to finance, look to CiX.com where private and hard money lenders compete to fund your next deal.