Commercial Classroom; Pricing investment properties - by Edward Smith Jr.

This column is offered to help educate agents new to commercial and investment brokerage and serve as a review of basics for existing practitioners. 

A potential buyer will want to see how the property is expected to perform this year and in the future. 

We start by creating an Operating Statement or Proforma, which is a projection of the expected income and expenses for this year. What are the actual base rents being paid by the tenants at this time. Landlords may also charge additional rent, which could include items like costs of electricity or water, share of real estate taxes or common area maintenance charges.  If the building has any vacancies, we must project what that space will be rented for based on current market conditions. The initial income portion of the analysis is completed as if the property is 100% rented. 

Then a contingency adjustment is calculated and subtracted for possible unexpected vacancy, giving us an adjusted tenant income. Some properties may have other income not from the tenants, which must now  be added to the adjusted tenant income. This could be fees charged for antennas on the roof, advertising billboards, or in apartment buildings a laundry room income. This  completes the Gross Operating Income portion of the analysis. 

Next, we must project the expenses that the new owner will have to pay. Ask the seller for a list of last year’s expenses and then review each item asking what the current cost is. This would include items like real estate taxes, insurance, utilities costs, contract services, accounting and legal fees, and possibly management fees. 

Many owners receive a Proffit and Loss statement (P&L) from their accountant. Be aware some items are legitimate expense for the current owner but would not be expenses of the new owner. For example, there could be a vehicle used for their business, but it is not being sold with the building, consequently any auto repairs or auto insurance expenses on the P&L would not be an expense of the buyer. The current owner has a mortgage and deducts the interest paid, that expense would not carry over to the buyer who may be buying all cash or getting their own financing. Mortgages are not considered to be expenses of the building and do not appear in an Operating Statement.

A prudent building owner will set aside some cash for emergencies; The IRS allows this contingent expense to be listed as an expense of the building, referred to as a Replacement Reserve or Repair and Maintenance Fund. An owner may be providing heat for the tenants and if the heating system fails, they would need to immediately replace it. However, if the money is not spent this year, it must be added back as an asset of the building when the income taxes for this building are calculated for this year.

At this point all the expenses are totaled and subtracted from the total income, the result being known as the Net Operating Income (NOI) or this year’s projected Cash Flow. These numbers must be accurate. When an offer is accepted to purchase a building and then it goes into contract the buyer or their representative will want a copy of the leases and expenses to verify the numbers.

The price for a property is derived using an Income Approach to Valuation, which is what the banks use in providing financing, and/or a comparison of prior sales or other listings currently on the market for similar buildings.

Using the Income Approach requires knowing the “banks” Capitalization Rates (CAP rate). Considered to be what Return on Investments (ROI), other investors are getting on these types of investments at this point in time. This must be looked at locally, where the property is located, as CAP rate varies by time and geography. When someone applies to the bank for a Mortgage, the bank wants to see the Operating Statement to determine if there is sufficient cash flow to pay back the loan. Then they use their appraised value of the building and their CAP rate to determine if they will finance the property. 

As a real estate practitioner, it is recommended that you make acquaintance with at least four banks in your area (you want a conscience) and meet with their representatives on a quarterly basis to determine the CAP rates they are currently using for each category of property you handle: Residential, Office, Retail, Industrial, Multi Family or Investment.

To determine the price for a property the following formulas are used:

• Annual Total Gross Income Less Total Operating Expenses equals the Net Operating Income (NOI).The NOI divided by the prevailing CAP rate for this type of property yields the Price.

• Getting ready to market the property the potential buyer will want details about the tenants: who they are, square footage occupied, current rent being paid and any additional rent, how long they have been a tenant in this building, what date did their current lease start on and what date does it end, and if they have any options to renew their lease. This is known as a Lease Extract.

In most investment sales Capital Gains Taxes will have to be paid. Sellers should discuss this with their accountants and get an estimate of their tax consequences before listing the property. 

Also discuss the possibility of doing a 1031Tax Deferred Exchange with a Qualified Intermediary, an individual or company that is required to conduct the exchange process. In this case, the Capital Gains Taxes could be deferred to a property being bought to replace the property being sold. Exchanges are complicated and have very specific rules and time limits.

Edward Smith Jr., CREI, ITI, CIC, GREEN, MICP, CNS, e-PRO, AHWD is a licensed real estate broker in New York and Connecticut with Smith Commercial Real Estate, Sandy Hook, CT.