Three Big Mistakes In Pricing Commercial Real Estate

Valuing New Orleans commercial real estate accurately can be www.louisianacommercialrealty.comdifficult at times, but using basic financial principles can help you calculate the market price with a higher level of confidence. Just remember that the price of any object is the equilibrium of supply and demand, but commercial real estate supply and demand can depend on emotional as well as logical factors. The challenge is to avoid these emotional traps and use rational analysis to price your property. Here are the three most common pricing traps that sellers fall into that are imperative to avoid.

1. I’m Just Going To Hold It Until I Get My Price

While the price the seller paid has nothing to do with the value of the property nor what the seller thinks it might be worth, many sellers use their purchase price as the bottom line they will take when negotiating a price with a buyer. It is called “benchmarking” and it is an easy mistake because nobody likes to lose money on an investment. In more cases than not however, a seller is better off taking the highest price they can get and then reinvesting their money elsewhere to recoup their losses  since trying to get an above market price might happen, but it might take you ten years to do so. You can prove it with math using the formula for present value: where i is the interest rate you can earn elsewhere and n is the time. Therefore if you wait 10 years to finally get a buyer at the $1,000,000 price you paid for property, you would have the same amount of money as if you sold the property today for $613,913 and put that money to work at 5% annually. This is a real disaster when holding land that does not appreciate in value since you still have to pay taxes and keep the grass cut.  

2. The Appraisal Was Much Higher

Appraisals are restricted to using three pricing methods:

a. Income Approach-value based on the net operating income the property generates.

b. Cost Approach-based on what the cost would be today to build your property.

c. Market Approach-based on what other properties in the area have already sold for, adjusted for inequalities.

The appraisal is always based on assumptions which, using today’s methods, don’t allow an accurate price. For example, the income approach assumes the tenant does not default on the income, that taxes and expenses do not increase and that current expenses stated by the seller are accurate. Rarely does an appraisal calculate net operating income including maintenance sinking funds, even though air conditioners and roofs have a finite life and need to be replaced. And these are very large expenditures which can easily eliminate a years’ rental income. The cost approach assumes you can build a new structure for a certain price, usually a per square foot estimate, when any accurate pricing would require a firm bid from a contractor based on specific drawings for the new project. The market approach assumes properties already sold would still have those buyers interested in your property and would have the same demand. Just because one person paid one million for the property down the road to build an apartment doesn’t mean a different person who wants to build a po-boy shop would pay the same amount, or that the apartment buyer would have any money left to purchase your property.  

3. It’s What I Paid For It

Buyers don’t care what you paid for it, just like the television show Pawn Stars, when someone walks in to sell an old item they bought long ago. The Pawn Store is only interested in what they can sell it for. Your cost is called a “sunk cost” in that you spent that money regardless of whether you hold or sell the property.

 The Best Method For Valuing Commercial Real Estate

Pricing commercial property accurately can depend on the use a buyer might have, so it pays to ask a lot of questions. Here is a real world example. The subject property is a 10,464 square foot vacant building with three separate spaces:  a 4,930sf restaurant, a 3,600sf retail space and a 1,934sf retail space.

10,464sf building has three separate spaces

10,464sf building has three separate spaces

This property could be sold to an investor who might rent the space for $16/sf, for a gross income of $167,424, if taxes and insurance costs are passed along to the tenants in a triple net lease.

Pricing Commercial Real Estate Using Net Operating Income

The price of any investment property, stock or bond, is the present value of future cash flows, adjusted for risk and opportunity costs. The income on commercial real estate is measured by Net Operating Income, which is the income stream generated by the operation of the property, independent of external factors such as financing and income taxes. Gross income includes both rental income and other income such as parking fees, laundry and vending receipts, and any other income. Operating expenses are costs incurred during the operation and maintenance of a property, including repairs and maintenance, as well as insurance, management fees, utilities, supplies, property taxes and others, but excluding principal and interest, capital expenditures, depreciation, and income taxes. For a 10,000 square foot property 100% leased at $10 per square foot producing income of $100,000 annually with expenses of $25,000 annually, the Net Operating Income would be $75,000. If a buyer needs a 9% Cap Rate, the price of the property would be $833,000. If the buyer felt there was more risk than normal and required a 12% cap, the price would be $625,000. If the property were a high quality AAA rated large company such as CVS or Walgreens, the same property with the same income would trade at a 5.5% to 6% Cap Rate since 30 year Treasury Bonds trade at 2.97%, resulting in a price of $1,363,000.

If the investor had to lease the space, the risk of leasing the space would be factored in and there would be an expectation at least a 15% cap rate to assume that risk which would value the property at $500,000, using the formula below.

cap rate

cap rate formula

The seller could be able to command a higher price simply by finding a user of one of the spaces who would buy the property and lease the two remaining spaces. Simply by putting yourself in the buyer’s position, you can determine the maximum price a buyer would pay. Here is how it works. A user, for example, of the restaurant is comparing the cash flows of buying versus leasing space. Using the “Law of Substitution”, the restaurant owner would compare the alternative of leasing versus buying this property, and the market lease rate is $16.sf, plus $3/sf triple net costs, for an annual lease cost on 4,930sf of $93,670. The buyer could justify purchasing the building if the costs were less than the lease cost. Here is the cost to the potential buyer at various purchase prices. cost spreadsheet If the potential buyer can lease elsewhere for $93,670 annually, he/she would not be willing to pay a price for the property which would result in a cost of more than that, after taking into account the rental income. The above spreadsheet can be graphed to produce a maximum price which is the intersection of the line of rental cost and the line of net purchase cost.

chart comparing purchase vs. lease decision

chart comparing purchase vs. lease decision

The maximum price for this property a buyer could justify would be $1,320,000 which would result in a cost of $93,670 annually which is the same as the alternative property lease cost. There are some considerations, such a tax savings from depreciation but that is offset by the tax when the property is sold since the recapture rate is close to the ordinary income rate. There is also the benefit of principal paydown on the mortgage note which is offset by the owner’s space cost of taxes and insurance and the maintenance and roof expenses. In summary, the best method to value a property is to put yourself in the most qualified buyer’s position and determine what the alternative costs are for the buyer, then price your property using basic financial principals..

Definitions:

benchmarking“- valuing a property not on the current market value or analysis but on some price you have in your mind that it is worth, based on what you paid for the property or a price someone, somewhere, long ago offered you that you turned down.

net operating income” – gross income less operating expenses (maintenance, insurance, property taxes, management expenses, utilities)  but before income taxes, interest and depreciation.

sunk cost” – past costs that have already occurred and cannot be recaptured.

cap rate” – capitalization rate. The rate of return used to value an income stream which can be composed of current and future income or expected capital gain.

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