How to Value a Commercial Property
Evaluating commercial real estate proposes fewer complications than evaluating residential property, where emotional factors and judgments about non-monetary issues, such as the desirability of the neighborhood and the comparative excellence of local schools, enter into the equation. For commercial real estate, the first and perhaps only consideration is the return on investment (ROI). If a subject property's ROI equals or exceeds the average ROI for properties in the area, the property's value equals or exceeds the asking price. If not, it doesn't. Calculating the Gross Rent Multiplier (GRM) will help you evaluate a commercial property by determining whether it compares favorably or unfavorably with similar properties in your area.
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Things You'll Need
- Asking prices and annual gross rents for a number of comparable properties for sale in your area
Instructions
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Determine the average GRM of several similar properties for sale in your area, the more the better. You can obtain gross rental income, expenses and other information on commercial property for sale from the realty company handling the property--often they have a handout sheet with this information on it. For each property, divide the asking price by the annual gross rents (AGR). If a property sells for $500,000, and has an AGR of $70,000, the GRM equals $500,000 divided by $70,000, or 7.14. Let's assume that you determine the GRM for six or seven similar properties in your area, and that the average GRM equals 9.
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Calculate the GRM for the property you contemplate buying. If the asking price equals $1,100,000 and AGR equals $90,000, the GRM equals 12.2. which exceeds the average GRM of 9.
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Determine the appropriate value of your property---one that equals the average GRM for similar properties in your area. Multiply the AGR, $90,000, by the average GRM, 9. The result equals $810,000. In this instance, you might consider countering with an offer to buy the property at $810,000 or somewhat less, anticipating a counter-offer above your initial offer.
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Tips & Warnings
The GRM approach provides a good comparative evaluation of any property. A more detailed analysis might also take into account the comparative net income to gross income ratio. This ratio will depend primarily on two factors: the age of the subject property (older properties will have higher maintenance and repair costs), and the property's condition. A property with a lot of deferred maintenance and other related issues will have higher future maintenance and repair costs. You may find it difficult to determine the cost of getting a neglected property back into good condition. A general rule of thumb suggests that, on average, the net income for commercial property (after management costs, utilities, insurance, taxes, maintenance and repair) will average around 50 to 60 percent of gross income. Always ask to see your property's expense records. If the expenses run significantly more than 50 percent of gross income, or if you see deferred maintenance issues that will drive up expenses, consider passing on the property.
Few owners of commercial real estate buy with 100 percent cash. Even if the GRM for the property pencils out, you need to determine if your net cash flow (the money you will have each year after payment of all expenses) equals or, better, comfortably exceeds your mortgage payments. If not, consider buying a less expensive property. Always leave yourself a cash flow margin--every real estate property will have unexpected expenses sooner or later.
References
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