Commercial classroom: How to list and price 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.

You will need to determine the potential income for this year, subtract from that the projected owner’s expenses to determine the expected net operating income (NOI) for this year. Sounds simple but it’s only the beginning of the process.

When the property is sold the buyer, or their representative will want to verify all the numbers during the due diligence period. If anything, as mentioned, is inaccurate the deal will not close!

Before meeting with the owner tell them at your meeting you will need from then a copy of their lease extract and a copy of last year’s income tax form for this building.

A lease extract is a chart that shows each tenant, how much space they occupy, their base rent, any additional rent, the date their lease started, the date their lease will end, the annual rent escalations and if they have any options to extend the lease.

To determine potential income, we begin with the actual rent of current tenants, adding to that the projected rent for any temporarily unoccupied spaces plus any additional rent passed through to the tenants (i.e. utilities, real estate taxes). Next a contingency adjustment for the possibility of vacancy is subtracted from the potential income. Sometimes buildings have income not from rent (an antenna on the roof, advertisements on the building, vending machines or with an apartment building a laundry room operation), this now needs to be added in. Now we have a complete picture of the potential income for this year.

If you ask an owner what they expect their expenses to be for this year they may give you their “best guess” or refer to their accountants income and expense statement. To be completely accurate refer to their income tax statement for this building last year, which will itemize the actual expenses as reported to the IRS. Review each item with the owner, asking if this expense will be the same this year or if it has gone up or down. Include in the expenses a contingency fund for emergency repairs or maintenance, predominately based on the age and condition of the property and the responsibilities of the landlord in the lease. For example, if they provide the heat, they need to have cash available if the heating system needs to be repaired or replaced.

Finally subtract the total anticipated expenses from the potential income to get the NOI for this year. A buyer may divide the net operating income by the asking price for the property to determine what return on their investment (ROI) they would have if they bought it all cash.

Other buyers may consider how will the property do in the future. To do so they will set up a five-year (or even longer) spreadsheet using this year’s numbers as a base then adjusting the income for future years based on each tenants’ rent escalations and using cost of living adjustments to reflect expense increases. Ultimately determining the projected NOI for each year, showing a buyer the projected increase in cash flow and future value.

Valuing investment properties is done by comparing the property to similar properties that have recently sold or are currently on the market for sale. Also, by using the income approach which banks will use to determine if they will provide a mortgage. This is done by dividing the NOI by a capitalization rate (CAP Rate) to determine market value of the property.

The CAP rate is set by commercial banks based on the information they get from actual purchases they have financed, specifically dividing the NOI by the sales price of those transactions. CAP rates change (usually not by much) periodically and are geographically sensitive to local marketing conditions.

Consider this: if you do a current year financial analysis of a property and divide the NOI by the prevailing CAP rate for that type of property, you will have a value that someone may pay to buy the property. But, if you present the numbers to a buyer using a five-year spreadsheet showing the projected value for each year using the current CAP rate, this may justify asking for a higher price now, based on the future value.

Edward Smith Jr. CREI, ITI, CIC, GREEN. MICP, CNE, e-PRO and CIREC program developer, is a commercial and investment real estate instructor, author, licensed real estate broker, speaker, and a consultant to the trade.