How to Evaluate a Commercial Real Estate Investment

Commercial real estate (CRE) investments can be an amazing addition to your investment portfolio. CRE is highly competitive, and with the right strategy, you can make  or lose  a fortune. Properly evaluating a piece of property requires attention to detail and an ability to assess the tangible and intangible aspects of a deal. In addition to assessing potential revenues and expenses over the first year after a purchase, you also must survey other aspects, such as overall neighborhood, visibility, and zoning.

Why Is Commercial Property Valuation Important?

Property values matter for several reasons, each of them equally important. For instance, buyers can get properties at a reasonable market value without overpaying if they have an accurate valuation. It works the same for sellers, too, as they use the property valuation to help maximize returns from sales. A seller can also use a property valuation to sell a property quickly, or at least in a timely fashion.

Property valuation also plays a role in financing. A lender or bank will only lend if a property is deemed valuable enough that it can:

  • Be used as collateral.
  • Generate enough revenue to pay back the loan.
  • Provide value to property shareholders.

Real estate investors and other professionals use a variety of methods for commercial real estate valuation. The method used normally depends on the property’s type, its location, or its intended use.

Commercial Property Valuation Methods

CRE doesn’t depreciate like some investments can. And, in some markets, commercial real estate values are actually increasing. In comparison to residential real estate, CRE almost always offers better return rates. But, as with all investments, it’s important to research each property prior to making a decision.

One of the ways you can value commercial real estate is by comparison. In CRE, it’s important to compare apples to apples. For instance, comparing the investment value of a hotel to that of an office complex won’t offer valuable information. Compare like building types or classes, using such data as their location and square footage.

Moving away from comparisons based on building class, data can be a bit murky. You must use various metrics that point to a better CRE investment. Some of the best metrics to use for the calculation include:

  • Net operating income.
  • Capitalization rate.
  • Cash-on-cash return.

Let’s examine these a bit closer.

Net Operating Income

Net operating income is the amount you have leftover after accounting for all operating expenses after revenue. To determine a property’s net operating income, or NOI, add every source of revenue the property generates, such as:

  • Rental payments.
  • Lease payments.
  • Parking fees.

Then you’ll subtract every expense. CRE expenses can include:

  • Electricity and other utility charges.
  • Maintenance fees.
  • Property taxes.

You do not count the property’s mortgage as an expense.

If you’re left with a high NOI, the property could be a good investment. If it’s low  or worse, negative  it’s likely the property isn’t a great opportunity and may not even be sustainable.

Capitalization Rate

A property’s capitalization, or cap, rate is a formula only used for an owner’s first year after property purchase. Cap rates take a look at how much an investor stands to earn the first year as an owner if they buy the property outright. After the property is purchased, an appraiser determines the property value because this measurement is based on the property’s price in a specific year. Cap rates also help an investor estimate the return the property will provide.

Cash-on-Cash Return

This metric illustrates how fast you can regain your original capital outlay. For instance, a retail building with a 50% cash-on-cash return rate means you’ll earn back your investment in two years. Calculating the rate is simple  divide your net operating income by how much you invested in the property.

Why Is Calculating Cash-on-Cash Return Rates Important?

Knowing how to evaluate a commercial real estate investment and how long it will take to earn your initial investment back helps you determine if this commercial property is a good investment for the long haul. The best cash-on-cash return rate depends on who you ask  some investment professionals say a rate of 8% to 12% is good, whereas other investors won’t touch a property offering less than 20%.

At the end of the day, this metric really depends on how much of a risk you’re willing to take, how large a loan you’ll need, and how this investment rounds out the rest of your portfolio. Thankfully, if you work with a licensed CRE investment agency, the advice for this decision will be part of your service package.

How Can You Find Commercial Investment Properties?

The best way to locate a commercial investment property is to partner with a buyer’s rep. Buyer’s reps are commercial brokers who work on your behalf as an advocate for your needs throughout the process. Two of the greatest benefits of working with a representative include:

  • Access to the deals in their pipeline.
  • Services are complimentary.

Brokers who use a service like ProspectNow have access to deals that haven’t even hit the market yet, or they just might know an owner who is getting ready to sell. And depending on the location of the purchase, the seller must pay the agent’s commission.

If you still have a few questions regarding CRE investment properties, you can also speak to a real estate lawyer, CRE mortgage broker, or a CRE broker.

Partner with ProspectNow

If you’re looking for a commercial investment, the owners and properties in our commercial database are a great place to start. We’ve been helping real estate agents, brokers, and investors find more leads, close more sales, and make more money since 2008. If you want to see what ProspectNow can do for you, reach out to one of our representatives today or sign up for a free trial.