Sunday, September 18, 2011
Commercial Deal Analysis
In previous blogs, I have explained to the new investor how to identify value of residential properties. Typically, this is done by analyzing comparable sales of other single family residences as similar to the subject property as possible. This is known as the Sales Comparison Method of analysis. Residential real estate brokers prepare a Comparative Market Analysis, or CMA, using this method.
With commercial properties, value is typically analyzed using the Income approach. Commercial properties are identified as any income property, including those multifamily properties over five units, and classes such as office, industrial, warehouse, and hotel. In recognition of Dave Lindahl’s upcoming presentation to REAPS, today’s blog will focus on how to value small multifamily properties.
Small multifamily properties of 1-4 units are typically financed as residential properties, and the value of these properties may be a combination of the two methods described above.
Investors may choose to be an owner-occupant or non-owner-occupant of these small multifamily properties, including duplexes, triplexes and 4-plexes. If the property is to be owner-occupied, then some of the more subjective and emotional criteria used to purchase a primary residence come into play. Does the property have curb appeal? Do we like the neighborhood? Do we like the layout? Will it be good for entertaining friends and family? How close is it to the office?
Non-owner occupant investors rely more heavily on a statistical analysis based on actual income and income potential. The most common (and most misunderstood) measure used to analyze a commercial property is the capitalization rate, or cap rate for short. Simply stated, the cap rate is a measure of risk. The lower the cap rate, the lower the risk. The higher the cap rate, the higher the risk.
Properties in high demand neighborhoods, with excellent rental history and little need for maintenance, generally sell for low cap rates. Investors are often more interested in holding these properties for consistent returns and future appreciation. Properties with higher cap rates are typically in less desirable locations, have more turnover or vacancy rates, and may have more maintenance and repair issues. Investors buy these properties for cash flow, and accept the opportunity for a greater upside potential along with the risk.
Cap rates are typically applied based on the rates at which other income properties in the same classification (multifamily) and same conditions are selling in the same vicinity. To determine cap rates, one takes the net operating income (NOI) of the property, and divides it by the price.
Cap rate = NOI/price
Net Operating Income (NOI) is calculated by taking the gross annual income from the property (primarily rents) and subtracting operating expenses and an estimated amount for annual vacancies. Operating expenses include management, maintenance and repairs, insurance, utilities, supplies and property taxes. They do not include principal and interest, capital expenditure, income taxes, depreciation or other financing costs.
Price may also be determined by dividing the cap rate by the NOI:
Price = NOI/Cap Rate
If one knows the value of any two of these terms, the third term can be calculated.
Other analyses that may be useful to an investor in analyzing a multifamily property is to look at the cost per unit to acquire the property.
Price/# of units = Price per Unit
Price per square foot is another useful measure:
Price/total square footage of building(s) = Price per square foot
Many investors also look at Gross Rent Multipliers. Lower numbers indicate a faster payoff for the property. This measure takes the annual gross income and divides it into the purchase price. It can be used as a very rough estimate of the length of time it will take for the building to pay for itself. The lower the GRM, the better for the investor:
GRM = Price/Gross Annual Income
I will be going over these and other deal analysis tools at my free Seattle Tour of Small Multifamily Properties, 1-3pm on Sunday, October 9th. REAPS members are welcome to attend. For more details, please call my 24-hour recorded hotline at 888-621-4999 x4.
Wendy Ceccherelli is the volunteer membership coordinator for REAPS. She has been a full-time real estate investor since 2006, and is the designated real estate broker for Home Land Investment Properties, Inc. Prior to her career in real estate, she spent twenty-five years as a government arts funder. More information on real estate topics may be found on her website at www.HomeLandSeattle.com