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When buying commercial real estate, one of the most important considerations is defining commercial property value. One needs to know both how much the property costs but also how much the property is worth. Putting a value on commercial real estate is a mix of science and art, though there are various proven methods for calculating correctly (or at least accurately).
Knowing the right amount to pay for a property will partly depend on whether the buyer plans to use the property for commercial purposes, to generate rental income, or to fix it up and flip it. This will help the buyer determine the price at which the commercial property will be profitable or whether it will be a losing transaction.
Looking at the cost approach to define commercial property value is a good way to start. This approach values the property as the land price plus the cost of constructing the building.
This approach assumes that the cost of the property also makes the assumption based on the property’s best use. In other words, a tract of land that sits in the middle of oil country and is far from urban centers would assume a value that is based on the use of the property to generate oil income as opposed to generating rental income.
Lenders use the cost approach when defining commercial property value for new construction in order to release funds with the completion of each phase of development. This approach provides a current value based on particular conditions, though it doesn’t account for the income that the property could produce or the price of competing properties.
The average rate of return on commercial property may vary widely by location and market conditions. That said, the S&P 500 Index says that the average return on investment for the real estate market in the U.S. pulls in at 8.6 percent.
Since the average return on investment will differ according to each commercial property investment strategy, there is no one right answer to “what is the average return on commercial property?” However, residential real estate tends to have an ROI of 10.6 percent while commercial real estate tends to have an average ROI of 9.5 percent. It’s also worth noting that REITs have an average return of 11.8 percent.
While there are several different ways to calculate the return on commercial real estate, one of the favored ways is to look at the cash on cash return.
A good rate will vary, but many experts believe that a rate between 8 percent and 12 percent can be considered a good return on commercial real estate. Again, a good return will vary from location to location and will be dependent on the particular rental strategy employed.
Determining what a good return on investment (ROI) on commercial real estate requires defining one’s investment goals as there is not one, straightforward answer to the question.
In looking at different commercial properties, it’s easy to see that it can be difficult to have high cash flow while also enjoying high appreciation. Commercial properties with strong cash flow are less likely to appreciate quickly while properties that appreciate more quickly typically do not have high cash flow.
Determining one’s investment goals as well as what will be considered a good type of ROI for the investor will be important. In some cases, it may be looking at cash flow. In other cases, a cash-on-cash return may be most important. Net operating income and cap rate are also important considerations when looking at what might be considered a good ROI on commercial real estate.
Internal rate of return (IRR) can also be a strong metric as it serves as an all-encompassing gauge of ROI. IRR looks at the rate of return earned on an investment within a specific time frame, including cash flow and profits from a property's sale. In other words, IRR is a property’s net cash flow along with expected appreciation and divided by target hold time.
This makes IRR a solid way to estimate a commercial asset’s performance of a window of time that you hold onto it. This does rely on heavy forecasting, which can make it fallible.
When calculating ROI, it’s important to consider the intangibles as well as things that can be predicted. Learning the different ways to calculate ROI can help an investor make grounded business decisions regarding commercial property and commercial property value.
To calculate the value of a commercial property, you can use the cash approach defined at the beginning of this article. You can also use the income approach, which is slightly different. The income approach links value to the rental income through the property's cap rate. The equation is:
Current Value = Net Operating Income / Cap Rate
Cap rate can be extrapolated from market sales of other similar properties in the same geographic location. It can also be adjusted to account for the unique features of the property.
This approach is beneficial in that it accounts for the recent sale activity of similar properties and it can also be adjusted for unique factors. On the other hand, it doesn’t account for collection loss and vacancy, which can sometimes bolster the value.
The sales comparison approach can also be used, which relies on prices realized from recently sold properties that are similar and in the same location. This approach is often used for residential properties rather than commercial use properties.
Defining commercial property value is not an exact science. It will require many different considerations and may change over time. Understanding the different calculations can go a long way in helping investors make the most accurate predictions about commercial property value.
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