How to Value Commercial Real Estate

As a commercial real estate agent, I hear from owners, buyers, and even real estate agents. I know the market and see what has sold on the MLS. While the actual sales price within your market plays a role in determining value, it is not the only thing.

Commercial property is primarily valued based on the income of the property. Most buyers are buying for cash flow. If the property you are looking at is vacant, investors look at the Prospectus, also known as the projected income.

The whole process of the valuation comes down to identifying the annual net profits. Below is the method I follow.

Collect the Documents and Other Information

Trailing 12 months of profit and loss statements (T-12)

The foundation of the process is the profit and loss statements for the last 12 months. not all self-managed properties have a clear profit and loss statement.

Rent Roll (RR)

This is the current list of all the units with the occupancy, number of beds and baths, sqft of the unit, current rent, and back rent (when applicable).

Net Operating Income (NOI)

After all the documents are collected, we determine the NOI. A relatively straightforward process. Still, it’s where all the differences of opinion influence the ending price. To determine NOI;

Add all the sources of regular income; rents, standard fees, etc.

Subtract all the regular expenses; wages, taxes, insurance, turnover, etc.

• Do not include CAPEX.

The remaining balance is the NOI.

NOI = Income – Expenses

Capital Expenditures (CAPEX)

The CAPEX are expenses that occur on a non-regular basis, like replacing a roof or water heater. CAPEX items are generally considered items that have routine maintenance or repairs to maintain serviceability. These items are covered later in the replacement reserve.

Capitalization Rate (Cap Rate)

The cap rate is the only time we look at the sale of other properties. The cap rate is what investors look at for their return rate. To assess the cap rate, look at the properties in the market that have sold. Divide NOI by purchase price, and the result is the Cap Rate.

Cap Rate = NOI / sale price

Replacement Reserves

Replacement reserves are the money required to fund emergency repairs on a property. Generally speaking, 5-7% of the gross annual income. Depending on the age of a property or the CAPEX Items. For example, a renovation that includes a new roof and replacement of most of the appliances and water heaters will have a lower replacement reserve than a building of the same age that has never been renovated.