To determine the worth of a single-family house, all one needs to do is look at recent sales in the area. But what about a business property if there aren’t any nearby structures like it? How can investors determine the worth of these special qualities with accuracy? Investors don’t use market comps to estimate the worth of commercial buildings; instead, they base their decision on income. To put it more specifically, the commercial value formula gives investors a consistent and dependable way to evaluate various commercial properties.
As a result, we’ll explain how the commercial value formula functions in this post, with an emphasis on how investors might benefit from it. We’ll discuss the following subjects in further detail:
- Introduction to the Commercial Value Formula
- Increasing Value with NOI: The Numerator Approach
- The Denominator Approach: Adding Stability and Value
- Final Thoughts
Introduction to the Commercial Value Formula
Appraisers and investors may quickly determine market value when a community includes hundreds of comparable single-family houses. The value may be determined by looking at a number of recently sold comparable properties, or “comps.”
However, this homogeneity and volume are lacking in most commercial real estate. Simply put, there aren’t enough similar commercial properties to support using a market comp method to value. In contrast, income-based methods are employed by appraisers and investors. To be more specific, parties calculate the value using a technique known as the commercial value formula. With reference to this formula:
NOI / Cap Rate equals property value.
Net operational income, or NOI, is determined by deducting all running costs from the rental income of a property (NOTE: mortgage interest and depreciation are not operating expenses). This method of valuation is sometimes referred to as the “income approach” because of the significance of NOI in the commercial value formula.
The theoretical return a property might provide on an all-cash (i.e., unleveraged) sale is what the capitalization rate, often known as cap rate, equates to. It would have a cap rate of 5%, for instance, if you paid $1,000,000 cash for an apartment complex that produced $50,000 in operational revenue. Mathematically:
Cap Rate = NOI/Property Value
The operational revenue and valuation of a property are two connected elements that affect cap rates, as this rearranged formula demonstrates. The risk and stability of a property are more specifically what determine the cap rate. Investors will pay more for a property if it produces consistent, predictable revenue, increasing value and lowering the cap rate. In contrast, inconsistent revenue increases the risk for investors, depreciates the value of the property, and raises the cap rate.
Investors are provided with two crucial tools by comprehending the commercial value formula and its related components. First, while not the only way available, this formula offers a means of comparing commercial assets that are otherwise unrelated. In addition, by dividing the formula into its numerator and denominator, investors have the chance to raise a property’s worth (and, consequently, investor equity), which is something we’ll cover in more detail in the following two sections.
The Numerator Method: Boosting Value with NOI
Again, the formula for calculating commercial value reads:
Property Value = NOI/Cap Rate
Mathematically speaking, there are two ways that investors can raise the value of a property: 1) by raising NOI, or 2) by lowering the cap rate. Let’s begin by using the numerator strategy.
Let’s say the cap rate for an apartment complex is 5%. You determine a technique to raise NOI by $5 each month for a total of $60 after examining rentals and costs. As a result, you raise the property’s worth by $1,200 ($60 in additional NOI / 5% cap rate), which is not terrible.
Let’s examine an instance from the actual world now. Consider paying $2,000,000 for a 5-percent-cap rate office building with an 80-percent loan-to-value mortgage.
- Initial Value: $2,000,000
- $100,000 initial NOI ($2,000,000 value x 5% cap rate)
- $400,000 in initial equity ($2,000,000 in value minus $1,600,000 in debt)
- You spend an additional $200,000 after the acquisition to upgrade the HVAC and communal spaces of the property, which enables you to raise rents for tenants while lowering operating costs. A 20% boost in NOI results from these upgrades.
- New NOI: $120,000 (up 20% from the original NOI of $100,000)
- $2,400,000 (new value; $120,000 new NOI; 5% cap rate)
- $800,000 in new equity ($2,400,000 in value minus $1,600,000 in debt)
You boosted NOI for a $200,000 more capital investment, and the property’s value grew by $400,000 as a result. In other words, for $600,000 in cash ($400,000 down payment + $200,000 in capital renovations), you obtained $800,000 in equity and possession of a $2,400,000 commercial property with a $120,000 NOI!
The Denominator Approach: Adding Stability and Value
By lowering the cap rate, or using a denominator strategy, investors can also raise the value of a commercial property. To restate, the lower the cap rate, the more consistent and predictable the property’s revenue is. On the other hand, a property’s profit is significantly riskier when there are high vacancy rates and erratic renters, which raises cap rates.
Investors have another option for increasing value by taking advantage of this link between risk and cap rate. That is, if you can increase a property’s revenue consistency, you may reduce the cap rate that goes along with it, increasing the value in the process.
Let’s build on the last illustration. Assume you modified the lease terms from annual to five-year gaps after upgrading the HVAC and common areas and negotiated new rents. You have reduced the possibility of vacancy and increased the stability of your revenue by requiring renters to sign five-year leases. Office buildings in the area that have comparable features, occupants, and lease periods often sell for a cap rate of 4% rather than the initial acquisition price of 5%.
The results are as follows when using this reduced cap rate:
- New NOI: $120,000 (up 20% from the original NOI of $100,000)
- $3,000,000 is the new value ($120,000 in new NOI / 4% in new cap rate).
- ($3,000,000 valuation minus $1,600,000 in mortgage) = $1,400,000 in new equity
- Your initial $600,000 cash investment has now generated $1,400,000 in equity and given you ownership of a $3,000,000 commercial property!
Final Thoughts
The figures above, to be clear, are for simple and fictitious circumstances. The crucial lesson for investors is the disproportionate influence that even seemingly insignificant changes in a property’s NOI or cap rate may have on value. The commercial value formula, especially when these two parts are combined, offers investors an outstanding instrument for pushing property appreciation.
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