*** Valuing Commercial Real Estate

It’s Based on Cash Flow, not Comps

If you’ve ever bought a house, you know how it works. The value of the house is almost always based on comparable sales. Comparable sales--or “comps,” as they are called--are homes similar in location, square footage, number of bedrooms and bathrooms, lot size, and type of construction.

Imagine you purchase a property that is worth $300,000. Its value is based on the comps--which means that the house next door likely sold for around $295,000, the one across the street for $304,000, and the one down the street for $299,000. So in that neighborhood, your property is worth $300,000.

The property has a tenant who pays $1,100/month. But he is leaving, so you put a new tenant in that pays you $1,300/month. Did the house go up in value? No, it’s still worth $300,000 regardless of what the tenant pays you. Why? Because its value is based on comparable sales.

How It Works in Commercial
Now let’s imagine you purchase a commercial building that is worth $1 million. It has a retail tenant who pays rent of $7,500/month. But this tenant is also leaving. And you know that the building has been under-rented--that’s why you bought it. So you bring in a better retail tenant who is going to pay you $9,000/month.

Did the commercial building just go up in value? You bet it did. Why? Because the value of commercial property is based on its cash flow, not on comparable sales. The higher the rent--and the higher the quality of the tenant--the more the building is worth.

In this scenario, you just replaced a retail tenant paying $7,500/month with one paying $1,500 more. Want to know how much your building is worth now? It jumped from $1 million up to $1.2 million! That’s right, you’ve just earned yourself $200,000 in equity.

And now you’ve got options. You can:

• Keep the building (and the nice monthly checks it’s bringing you)
• Refinance, and pull up to $200,000 out, or
• Sell the building and take your profits!

Decisions, decisions!

Cash Flow vs. Comps
As you can see, commercial and residential use two different methods for valuing property. With residential, it doesn’t matter what your tenant pays you--it simply won’t affect the value. Your rental property could be vacant, and that wouldn’t affect its worth. It would still be based on comps.

On the other hand, the potential of a commercial property can be as limitless as your imagination. Because the value is based on income, you boost the value of the real estate every time you boost the income (rent) you’re receiving from the building. By scouting for commercial properties that are either under-rented or have inferior tenants, you can find potential gold mines.

Resources
Commercial Real Estate Investing
Trump University’s Commercial Real Estate 101