Investing in commercial real estate can seem intimidating, but the principles are the same as with any other investment property. To make a good financial decision, you need to understand the property you're considering, your path to monetizing it, and — most importantly — the relative profitability of one investment against another.
To this end, there are many different financial models for appraising investment properties. The three most common methodologies are as follows:
The Income Approach (or Capitalization Approach) determines value by considering a property's net operating income. This is the most common model and the one we'll be working with.
The Replacement Cost Approach looks at the hypothetical cost of reconstructing a property from scratch — including the cost of the land — and measures that against the listed property value.
Lastly, the Market Value Approach (or Comparison Approach) establishes an expected property value based on the values of similar, surrounding properties.
Often, many methods will be considered in tandem when evaluating a potential investment. This holds especially true for commercial properties due to the relatively larger impact of small differences between buildings. Such influencing factors include the property's physical condition, square footage, lot size, building materials, age, and location, as well as outside factors like local taxes and projected market growth.
How to Appraise Commercial Investment Properties
When taking the Income Approach to appraising commercial properties, one must understand how to read the following formula:
ROI = NOI / cost of investment
ROI is the return on investment, expressed as a percentage of the initial cost (which is the cost of investment in this formula).
NOI is the net operating income, which has its own simple calculation:
NOI = net income - net expenses
The utility of this measure comes down to how accurately you can estimate rental income (this is where you may want to consider a Comparison Approach) and operating expenses (you'll have to look at everything from insurance policies to maintenance costs to property taxes). The more precisely you can estimate your income and expenses, the better your model will be.
Performing these calculations will then allow you to look at key metrics like cash flow (NOI - mortgage payment), cap rate (NOI / current property value), and cash on cash return (NOI / total cash investment) for any property.
Clever's Free Commercial Property Cost Estimator
To make things easier, we've created a free financial model designed to quickly and easily calculate the value of a potential commercial investment property. This public Google Spreadsheet has a simple form on the Property Specs tab and a corresponding value estimate on the Report Output tab. All you need to do is make a copy of the spreadsheet and then edit in the numbers of the property you're considering.
Once you've filled in the values and generated a report, you'll be able to see a lot more than expected ROI. You can pore over important metrics like the aforementioned cash flow, cap rate, and cash on cash return, as well as other values like property appreciation and your growing equity over a 30-year mortgage. If you fill out the spreadsheet for multiple potential properties, you can compare these values against your investment goals to determine which property to purchase.
Of course, this model is no substitute for the full due diligence required when purchasing a commercial building. As mentioned, there's an array of factors to consider that aren't necessarily captured by a single financial model.
If you're considering purchasing a commercial property and want to get custom, professional guidance that takes these factors into account, connect with a local real estate agent who specializes in investment properties. Clever Partner Agents are all top performers in their local markets, so Clever can help you understand the value of a commercial property no matter where you're located in the country.