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How Much is My Commercial Building Worth?

Nov 29, 2017
Article #381
Author: Mel Jones

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So you own the real estate as well as the restaurant business.  Congratulations as that was a smart move you made as we see landlords getting greedy yet again. 

I was a former Chief Financial Officer for a fortune 20 company and I did business valuation all the time. Not only that, my degree is in finance and real estate. As my professors would drill into my head, the value of an asset is worth the discounted cash flow it generates. In plain English, a piece of real estate is generally worth the annual income it generates (fair market net rents) divide by expected return. 

SIMPLE FORMULA

Let me write that in numbers. If an asset (building) generated $100,000 a year in net rent income to the owner and if the market expected returns are 7%, then the value is $100,000/7% or $1,428,571. 

NET RENT INCOME

So there are two elements that need further investigation. First, and the easiest to determine, is the net rent income to the property owner.  One can determine that by looking at the profit and loss of the property.  That statement should show the gross rent incomes less the costs less a vacancy factor.  But not that fast!  Sometimes a restaurant owner will not pay him/herself fair market rents.  So the property profit and loss needs to be adjusted to reflect that.  Then apply the expenses to generate the net rent income.  Small variations in this number can have a large effect on the property's value. So be diligent. 

EXPECTED RETURN

The expected return, also referred to and the capitalization rate (cap rate) is the more challenging element to determine as it has a number of variables pulling at it from many directions. For example, when the economy weakens, the cap rates tend to go higher.  The higher the cap rates, the lower the value of the property. When interest rates increase, cap rates tend to increase because money will flow out of property into higher yielding and safer bonds.  In short, interest rates pay a role as well as the state of the economy. There are also local forces at work with the availability of commercial real estate on the market. The more real estate that's on the market, the lower prices are driven and the higher the cap rates. 

Another factor is the risk of the income flows from the property. For example, if the space is leased to Wal-mart, rest assured it is a pretty safe almost risk-free investment and the cap rates as a result will be lower.  While if is a single use property, such as a restaurant, the risk is higher.  In the case of Wal-mart, the cap rate may be 3.5% while the single use restaurant could be 10%. 

In short, there are books written on how to estimate a rate of return for a given asset.  An astute broker will have his/her pulse on the market cap rates for a particular piece of property and should be consulted. 

SUMMARY

Valuing a piece of commercial real estate has an element of art, but a lot os science as well. It takes a trained individual to properly value the real estate.  This article is merely intended to help one understand the general concepts of valuing a commercial real estate property. 

 

 


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