When speaking with a client recently, the topic of pricing commercial property came up. We were talking about a property that was listed for $499,000 and had an assessment of $250,000. The client felt that the property was drastically overpriced. My response was that the property was not overpriced, but under priced. How can that be they asked? It’s offered for twice what the town feels it is worth for taxation. Isn’t that the classic definition of overpriced? Well, yes if you were talking about a home or a commercial property where the buyer the end user. Commercial properties that are leased need to be seen as investments and priced accordingly.
If you invest in the bond market (pretty scary these day) and you buy a bond for $100 that pays $2 in interest at the end of the year, then you made a whopping 2%. This is called Return on Investment (ROI) or the CAP rate. In the go go days CAP rates were 10 to 12% but CD’s were paying 4-6% as well. Nowadays if you can a CD to pay you 1% you’re doing well. We use CAP rates in the 5 to 8% range these days, but that’s still 5 to 8 times what you’ll make in a CD. So, applying this reasoning to Commercial property, we can work backwards to arrive at a price for the property. We do this buy computing the net income that the commercial property generates (rent less any expenses e.g. taxes, utilities, maintenance, etc.) and then determine what sort of investment at a rate we are willing to accept this would require. The investment amount would then be how much we could invest in the property.
Using the example above: if we know that the property is leased for $3000/mo NNN (Net, Net, Net- this means that the person leasing the building pays all the expenses on the property), the annual return (ROI) is $36,000. Now, how much would you have to invest if you knew the rate of return (CAP rate) was 5% to make $36,000 a year? Easy huh, all you math wizards know you divide the ROI ($36,000) by the CAP rate (5%) and get $720,000. This is how much you would have to invest in something/anything to achieve the desired return. $720,000 is how much the property is worth.
The property is a good deal at $499,000 and actually under priced to return our desired 5%. If all the assumptions are correct, it will generate a return of 7.2% if we buy it for $499,000. The added nicety of commercial property is that there is the chance of appreciation. I know lately this is not the case, but it is not unrealistic to expect things to improve in the future.
What can you take away from this is simple: commercial properties that are leased are investments and are priced accordingly. If you are considering investing in commercial property, do so carefully. The above example is grossly simplified and used for example only. Use a reliable broker. I’ve spent six years in commercial sales and own my own commercial properties. I can help you through the process.
I’ll deal with pricing businesses in another blog. That gets interesting.