commercial office space
Hello, I am new to commercial side of real estate. I am looking at how commercial office space is appraised. There are around 50 similar commercial office spaces, when they were build in 1990's they all were sold at approximately $120 per square foot. But recently they were sold at a very different prices per square foot. Some are really 1.5 times more than the others. My question is how it could be explained? From the outside they all look the same, but different square footage of cause.
Thank you ! K
"My question is how it could be explained?"
Some might have a strong NNN tenant in place with 10+ years left on the lease, and it might be a big corporation that you can take to court if they ghost on paying their rent, while others might be office suites broken up into small offices on 6-36 month leases with shaky tenants like a nutrition supplement MLM that uses the office for 3x a week rah rah meetings on how to recruit more people into the pyramid scheme, that are immune to law suits b/c you can't squeeze juice out of a rock. In the middle of those two extremes might be a small business with 3 years left on their lease, but they've made improvements to the property that aren't cheap to remove, such as perhaps a dental office (dentists might be pissed that I put them in the mid-risk category, but all the dentists going out of business in 2020-2021 taught us that American consumers apparently regard dental care as an optional and "luxury" spending item).
You wouldn't pay more for a home with a really strong tenant b/c even the strongest tenant typically has <12 months left on the lease.
Take a look at the cap rates. Made up nice round numbers, and yeah these are extreme just to highlight the concept:
MLM tenant: 8% cap is appropriate based on comps, paying $100k/yr. $100k / 8% = $1.25m.
Dentist: 7% cap is appropriate based on comps, paying $100k/yr. So $1.428m
Edward Jones Financial Advisor, and Edward Jones is the guarantor of the lease (not a franchise owner[1]): 6% cap is appropriate based on comps, paying $100k/yr. $1.67m.
You might say "that's bs, the offices are identical!" -- and someone more cynical who has been around the block a few times might say "yeah but Edward Jones is a solid tenant, that's super low risk, and they've been there for 15 years already, and are 2 years into another 15 year lease."
To make it equivalent to a house or a triplex, you could think of the tenants as the "neighborhood." Both your tenants and other tenants contribute to what that "neighborhood" looks like.
Other things that come up are neighboring businesses. To switch to retail in order to use an extreme/silly example, take an organic vegan gluten free small grocery store with 1 year left on their 10 year lease. Six months ago, the property owner was silly enough to let a cigarette store move in next door. That's a giant red flag for that grocer potentially declining to renew their lease, vegan gluten free customers don't want to walk through a cloud of cigarette smoke to get to their ethically sourced non-GMO organic avocado, and obviously the "no smoking within 50 feet" sign is going to be ignored by the customers of that neighboring business, who are all a bunch of smokers. A residential landlord doesn't necessarily have any influence over the financial success of their tenants, nor do they care b/c they can just re-fill the unit in a month anyways.
A commercial landlord DOES care, and CAN impact the success of their tenants, and may NOT be able to re-fill the unit in a month. Back to your office space, are you going to let an optometrist rent the space next to a law office? Sure, why not, that actually adds to the professional community, I'm sure the accountant one unit over wouldn't mind either. Are you going to let an optometrist rent a space next to another optometrist? I don't know, but you would 100% want to check in with the existing optometrist, maybe they don't get "walk in" business anyways and do not care and wouldn't mind the like-minded neighbors (I've had mortgage neighbors before, and do not care -- I do mortgages they don't, case in point office mortgages across the country, so I wind up getting business from them), but an ice cream shop is going to be LIVID if you rent the unit next store to a frozen yoghurt shop, since that's a LOT of walk-in business that's now getting split two ways
And then to make it really fun, here's the question I'll throw back at you. Say it's 40% vacant. How do you determine the value now?
[1] I have no idea if Edward Jones locations are franchise or corporate.
Thank you very much for detailed explanation! So basically what appears to be going on in commercial real estate is if two identical offices are leased for different amount of money they have different market value. Does resent comparable sales impact office values in same building at all or we only need to look at CAP rates and determine the value based on CAP rates alone?
I do not really know how to determine value if it is 40% vacant... Maybe we need to know why it is vacant first? If it could not be rented then my guess it will valued at the same concept of CAP rate. This is my guess.
Quote from @Konstantin Komkov:You can/should look at comparable sales if you can, but you're using that mostly to determine appropriate cap rate.
Thank you very much for detailed explanation! So basically what appears to be going on in commercial real estate is if two identical offices are leased for different amount of money they have different market value. Does resent comparable sales impact office values in same building at all or we only need to look at CAP rates and determine the value based on CAP rates alone?
Suppose the unit in the building you are looking at is, in fact, in the middle of a 15 year lease with a strong tenant. What if there are no other units of similar size similarly situated have recently sold? Great, find one that's 5x as big that has recently sold. Cap rate lets you normalize that.
Quote from @Chris Mason:
Quote from @Konstantin Komkov:You can/should look at comparable sales if you can, but you're using that mostly to determine appropriate cap rate.
Thank you very much for detailed explanation! So basically what appears to be going on in commercial real estate is if two identical offices are leased for different amount of money they have different market value. Does resent comparable sales impact office values in same building at all or we only need to look at CAP rates and determine the value based on CAP rates alone?
Suppose the unit in the building you are looking at is, in fact, in the middle of a 15 year lease with a strong tenant. What if there are no other units of similar size similarly situated have recently sold? Great, find one that's 5x as big that has recently sold. Cap rate lets you normalize that.
Thank you very much! Your information put a lot of clarity! How could I learn more about commercial real estate and valuations and CAP rates? Maybe there is a book you could recommend?
Quote from @Konstantin Komkov:
Quote from @Chris Mason:
Quote from @Konstantin Komkov:You can/should look at comparable sales if you can, but you're using that mostly to determine appropriate cap rate.
Thank you very much for detailed explanation! So basically what appears to be going on in commercial real estate is if two identical offices are leased for different amount of money they have different market value. Does resent comparable sales impact office values in same building at all or we only need to look at CAP rates and determine the value based on CAP rates alone?
Suppose the unit in the building you are looking at is, in fact, in the middle of a 15 year lease with a strong tenant. What if there are no other units of similar size similarly situated have recently sold? Great, find one that's 5x as big that has recently sold. Cap rate lets you normalize that.
Thank you very much! Your information put a lot of clarity! How could I learn more about commercial real estate and valuations and CAP rates? Maybe there is a book you could recommend?
No book, I just do the mortgages and talk to folks.
Quote from @Chris Mason:
Quote from @Konstantin Komkov:
Quote from @Chris Mason:
Quote from @Konstantin Komkov:You can/should look at comparable sales if you can, but you're using that mostly to determine appropriate cap rate.
Thank you very much for detailed explanation! So basically what appears to be going on in commercial real estate is if two identical offices are leased for different amount of money they have different market value. Does resent comparable sales impact office values in same building at all or we only need to look at CAP rates and determine the value based on CAP rates alone?
Suppose the unit in the building you are looking at is, in fact, in the middle of a 15 year lease with a strong tenant. What if there are no other units of similar size similarly situated have recently sold? Great, find one that's 5x as big that has recently sold. Cap rate lets you normalize that.
Thank you very much! Your information put a lot of clarity! How could I learn more about commercial real estate and valuations and CAP rates? Maybe there is a book you could recommend?No book, I just do the mortgages and talk to folks.
Thank you!
-Tenant mix - buildings with a good mix of stable, creditworthy tenants will be seen as less risky and could sell for a higher price per sqft.
-Recent renovations - the more modern the interior is and more functional increase its value
-Floor plans - you could have two identical office buildings but one with a better floor plan will sell for higher per sqft.
-Submarket - the specific area in the city will have a big influence. Even if a property is 3 miles away, you will notice price difference if it falls on the other side of the highway for example.
-Visibility - corner locations or offices with prominent signage might attract more buyers.
I would suggest walking the buildings to get a better feel of the properties. Hope this helps.
Quote from @Sohail Bas:
A few reasons why similar office / retail spaces are priced differently from my experience.
-Tenant mix - buildings with a good mix of stable, creditworthy tenants will be seen as less risky and could sell for a higher price per sqft.
-Recent renovations - the more modern the interior is and more functional increase its value
-Floor plans - you could have two identical office buildings but one with a better floor plan will sell for higher per sqft.
-Submarket - the specific area in the city will have a big influence. Even if a property is 3 miles away, you will notice price difference if it falls on the other side of the highway for example.
-Visibility - corner locations or offices with prominent signage might attract more buyers.
I would suggest walking the buildings to get a better feel of the properties. Hope this helps.
Thank you! That makes a lot of sense!
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OP. Commercial appraisals are based on three approaches:
a. Cost to build.
b. Comparables
c. Value of Net Operating Income, Cap rates.
Cost to build approach has not kept up with inflation. They use 20 year old averages. Thus this approach will undervalue the building.
Comparables- As noted by the other responders, this is very hard to do. Exact same business and building. Both on a 35 MPH road. One has 3,000 and the other has 17,000 vehicle traffic.
Value of Net Operating Income- you have to be able to do the due diligence and vet the properties. Lots of good input above. You can't do a broad brush stroke, even if all of them are the exact same building.
This is where you as the investor can bring more to the table to identify or create value.
Quote from @Henry Clark:
OP. Commercial appraisals are based on three approaches:
a. Cost to build.
b. Comparables
c. Value of Net Operating Income, Cap rates.
Cost to build approach has not kept up with inflation. They use 20 year old averages. Thus this approach will undervalue the building.
Comparables- As noted by the other responders, this is very hard to do. Exact same business and building. Both on a 35 MPH road. One has 3,000 and the other has 17,000 vehicle traffic.
Value of Net Operating Income- you have to be able to do the due diligence and vet the properties. Lots of good input above. You can't do a broad brush stroke, even if all of them are the exact same building.
This is where you as the investor can bring more to the table to identify or create value.
Thank you! I wonder as of why in Cost to build approach they use 20 years averaged numbers? doesn't make any sense as you pointed due to inflation.
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Quantity of income (amount of NOI)
Quality of income (likelihood of NOI)
The former is harder to collect, but the latter can be public data.
Quote from @Ronald Rohde:
Quantity of income (amount of NOI)
Quality of income (likelihood of NOI)
The former is harder to collect, but the latter can be public data.
thank you, could you explain where to find this info. In which public data?
Take some courses with the appraisal institute and you will learn and meet valuation professionals that have a wealth of knowledge.
Quote from @Jonathan Bock:
Take some courses with the appraisal institute and you will learn and meet valuation professionals that have a wealth of knowledge.
thank you! what is appraisal institute?