The value of a commercial property for sale is determined by using some simple formulas that are based upon the amount of net operating income that the property produces each year. So when you are looking at a commercial property for sale, one of the first things that you’ll want to ask the broker for is the profit and loss statement.
Some brokers who have listed a commercial property for sale may refer to this profit and loss statement as an IPOD, or income property operating data sheet. Once you get the IPOD, or profit and loss statement, you can then compare the information provided by the broker or seller to your other sources to help determine what the real numbers are. The challenge when looking at any commercial property for sale is that the broker and/or owner will often tend to exaggerate the amount of income that the commercial property for sale produces while also trying to minimize the amount of operating expenses that are reported.
How to Determine the Value of a Property for Sale
The reason for this is simple. The value of any commercial real estate is based on the amount of net operating income the property creates each year. In fact, each additional dollar of annual income increases the value of the property by roughly ten dollars, depending on where the property is located, and how old it is. Note that this extra net income can come from either getting additional revenue in rents, or from reducing expenses by managing the property more efficiently.
Once you understand that owners of commercial real estate will tend to present unrealistic numbers in an attempt to get a higher price for their property you’ll understand better why it’s necessary when looking at any commercial property for sale to get to know the market you are investing in. When you know what the rental rates in an area tend to be or what the typical expense ratios are for a twenty-five year old apartment building then it’s much harder for the broker or owner of a commercial property for sale to attempt to pull the wool over your eyes.
Verifying the Income and Expenses
The first step in verifying the income of a commercial property for sale is to ask for the rent roll. The rent roll is a list of what each apartment, self storage unit, mobile home lot, or office space rents for. Make sure that you get the actual rent roll because the owner or broker of a commercial property for sale may try to give you a Pro-forma rent roll instead of the actual rent roll. Pro-forma means that there is an expectation, realistic or not, of getting higher rents than the property is currently getting. My response to this has always been, “If you raise the rents up to match the pro-forma, then we’ll use the higher income amounts, otherwise we’re going to base our valuation on what the property is currently producing in income.
When looking at the expenses from a commercial property for sale, remember that you’re trying to come up with the actual amount that it will cost you to operate the property rather than what the seller’s expenses have been. So while it’s helpful to know exactly what the seller’s costs have been, I’ve learned NOT to rely on the information provided by the seller when looking at a commercial property for sale because this information is almost always inaccurate.
A Simple Formula to Use for Expenses
The expenses will vary depending on the type and age of the commercial property for sale. For example, if you are looking at buying a Class C apartment building which is at least twenty-five years old, then the expenses will run between 45 to 50 percent of the collected income each month. The collected income, known as the Effective Gross Income, is what’s left after the cost of vacancies are subtracted from the total amount of rents on the rent roll from the commercial property for sale.
The final step in determining the value of a commercial property for sale is to divide the net operating income by the capitalization rate, which varies from about 6 to 12 percent depending on the type of property, the age, and the location of the commercial property for sale. The fastest way to get an idea of what capitalization rate you should be using when looking at a commercial property for sale is to ask another broker who is not involved in the transaction.
Using Escape Clauses to Limit Your Risk
Another way of protecting yourself when looking at any property for sale is to make sure that your purchase contract allows you a period of time to get out of the deal if you are not comfortable with anything that you find. Done properly, you can often tie up a property for 60 to 90 days so that you have time to accurately determine the real value. This makes it easier to look at commercial real estate, because you can get out if you have the right escape clauses.