Commercial real estate in New Orleans is often valued incorrectly which can be a disaster, but it also creates opportunity: big money is made when you understand how to value commercial real estate correctly. This article examines three basic mistakes anyone can make when valuing commercial real estate.
The first mistake commercial real estate buyers and sellers make is to depend on appraisals, whose main function is to finance the property by allowing a bank committee to say they used a logical process to make a loan to purchase the property. The appraisal value is not the same as the market value and here’s why: the appraisal looks at past sales and corrects for physical differences. Makes sense but the past is not the future. The basic assumption in all appraisals is that it assumes that the past sales that took place between a willing buyer and seller would repeat themselves. In reality, commercial real estate is always purchased by a buyer who has a specific use for that specific property and may not have the same use for an additional property even though it is similar. Often commercial real estate buyers will value a property because they can generate a certain cash flow from a business on that property. We cannot assume a nearby property has the same valuation for two reasons:
- The buyer may have spent all their money. They may not be willing to purchase any more property, even at the same price.
- Another buyer may have a different use for the property which would generate a different cash flow and therefore a different valuation for the property.
A good example of a useless appriasal was the purchase of a 40,000 square foot of land at 1667 Tchoupitoulas in New Orleans in June 2006 for $1.1 million, based on an appraisal and financed by Gulf Coast Bank. The buyer was unsuccessful in flipping the property and put it back on the market for sale, eventually giving it back to the bank who sold the property in December 2011 for $600,000 to Infiniti Fuels who will build a convenience store on the site.
The second big mistake made in valuing commercial real estate is to depend on the last sale price. Often a seller believes that the market value of property is what he paid for it plus some carrying cost. Psychologically this is called “benchmarking”. In reality, the market price is what a willing buyer would pay for it, which is more accurately predicted by what other properties match his needs. This is called the “Law of Substitution”, because any buyer will ask themself, “Why should I pay one million for your property when I can get the same property down the street for $750,000?” One excellent way to determine market value is to research what other properties are selling for.
The third mistake in valuing property is not understanding “Opportunity Cost” which is the unit of some commodity “A” given up in order to obtain the same amount of commodity “B”. By overvaluing commercial real estate, a property could sit unsold for several years, resulting in the owner losing the opportunity to invest those proceeds in another property, or the stock market, or give to grandchildren to pay for a college education. Smart commercial property owners understand a financial ratio called “Return on Assets”, which is your property’s net income divided by the value of the asset. With commercial real estate, your return is the rental income plus capital gain and property is often held several years. If you buy land for one million and forego the opportunity to sell the property for $1.5 million in 5 years because you think the property is worth 2 million, you might get your price but it might take you another 5 years to do so and your return on your asset would be 6.95% per year, not including taxes and insurance and time and property management expenses. Had you sold the property for less at $1.5 million in a shorter period of time of 5 years, your return on assets would have been 8.13% per year. Really smart commercial property owners not only know the return on assets but compare all their investments and allocate resources to the investments that have the highest return on assets with some adjustment for risk. In financial economics this is called riding the “Efficient Frontier”, and it works for Mark Cuban and can work for you too.