If you are in the flipping game hopefully you know everything, there is to know about comps. You look for properties with similar features, see what they sold for and badda-bing you have a sense of a property’s potential.
Commercial property valuations are the subject of MBA dissertations, meaning they aren’t simple. In the end, comparable sales won’t give you a real sense of what a commercial property might be worth.
You might be prospecting through various listings and come across two apartments to flip, a 4-unit apartment building selling for 75 and a 5 unit one selling for 150. Conventional wisdom says one unit won’t make much of a difference in the end, so the one listed at 75 is a better deal, right?
Commercial properties are valued based on the income generated, you can’t just rely on comps; income must be accounted for to assess a property accurately. So how do you do that?
Using income to evaluate a property is done per the following formula:
Net Operating income/cap rate
What is a cap rate one may ask? Annual income/property value. But who determines the cap rate? No one knows precisely, owner set rents and therefore income and the market set the value of a property.
For the sake of illustration, let’s say the cap rate for both properties is 7.7%, and the average rent in the area is 1,500 per unit. You may walk through and get the same estimate when it comes to repairs on both properties, 450 thousand.
The four-unit apartment still looks pretty attractive, but hold on let’s use the formula:
4 unit building can earn, 72 K a year
72,000 /.077= 935,064-450= you’d earn 335 thousand dollars given the rehab. Well, that’s good, and you might be asking yourself how much difference can a single apartment make?
The 5 unit building can earn, 90 K a year
90,000/.077= 1,168,831, you’d earn about 568,831 dollars on this deal basically an extra 200,000 dollars because of one apartment. Had you relied on conventional fix-n-flip wisdom, i.e., That a bedroom only adds so much value or that a lower sales price is always better, you would have missed out on 200 K in returns.
Reality isn’t as clear-cut as the examples above, but the message is clear, you can’t evaluate the potential of a commercial flip based on comps.
Getting a sense of how much income a property can generate gives you a sense of its potential, use formula, NOI/cap rate. Set the NOI based on the average monthly rent that you could charge per unit and use the prevailing market cap rate. Perform these evaluations before you take out a loan. That one piddly apartment unit could result in 100’s of thousands of extra dollars in returns on your next commercial flip.
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About the Author: Dennis has been working in the real estate industry in some capacity for the last 40 years. He purchased his first property when he was just 18 years old. He quickly learned about the amazing investment opportunities provided by trust deed investing and hard money loans. His desire to help others make money in real estate investing led him to specialize in alternative funding for real estate investors who may have trouble getting a traditional bank loan. Dennis is passionate about alternative funding sources and sharing his knowledge with others to help make their dreams come true. Dennis has been married to his wonderful wife for 43 years. They have 2 beautiful daughters 5 amazing grandchildren. Dennis has been an Arizona resident for the past 40 years.