“I think we’ll just have a market analysis done.” That’s what the CPA said to me and my client as we discussed the value of a commercial building that my client was considering buying from the CPA’s client. I had just walked everyone through the very simple math of commercial property valuation and showed what the value of the building is. But that wasn’t a number that they liked.
Let me take a step back to define some terms and lay out the simple formula:
Net operating income or NOI: Start with the net income of the property (income – expenses) and add back depreciation and mortgage interest. Similar to net free cash, it tells you how much money the property will produce if you buy it in cash or how much money you’ll have to cover the debt service.
Capitalization rate or cap rate: Think of it as the rate of return. A good local commercial realtor can tell you what the average cap rate is in your area.
Commercial property valuation formula: NOI divided by cap rate. It really is that simple.
Back to the conversation with the CPA and his client, I laid out the basics of the formula after I realized that this concept was new to them both. I then referenced two properties that had sold recently in the area where all of the figures were known. The listings for both properties included the NOI and simple math showed that they were being listed at an 8% cap rate. A quick web search found the sale prices which showed that they had both sold for closer to 9%.
Returning to the subject property, the owner was hoping to get $600,000 - $650,000. The building is a retail building with one tenant paying ~$40,000 on a triple net lease (less the real estate taxes of ~$4500). This would yield an NOI of $35,500. At an 8% cap rate, the value would be: $443,750. At a 9% cap rate, the value would be $394,444. It was at this point that the CPA spoke up, not realizing that a market analysis would look at cap rates of recent properties and apply those to the NOI of the building.
Were we at an impasse? Not at all! It was at this point that I brought up the possibility of owner financing. The owner agreed, and this simple strategy will put more money in his pocket at a lower sale price for the buyer. A true win-win. More on that strategy in another blog.
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