Get commercial real estate analysis right, and you’ll be able to select profitable properties and avoid loss-making ones.
Going through the motions to create a thorough commercial real estate analysis can be the difference between banking a profitable commercial real estate investment – or going bust.
Typically, many investors reduce commercial real estate analysis to just cranking out numbers to determine property values so as to ensure they are paying a fair price. (Yes, valuation is important, but it's just part of the larger process.)
However, as we will see, there are other qualitative factors that a sound commercial real estate analysis must include.
In this article, we will consider the various aspects of commercial real estate analysis and what you need to do to build a profitable portfolio.
We’ll cover:
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Making money is the goal of every CRE investor, irrespective of their investment strategy (flipping properties or holding them for rental income).
But the ability to sell a commercial real estate property or get rental income from holding it depends on the state of the local market (or submarket) where the property is located.
Yes, the property will make for a nice restaurant but is the local market interested in a restaurant at this time? A search through the local market can show that there are already too many restaurants and that some of them are even struggling to stay afloat.
To take another example, the fact that a property will be good for office space does not mean the local market will support demand for office spaces. What if businesses are closing more rapidly than they are opening and there is high vacancy rates for these property types?
If the property is suitable for the market, then what rent can you expect to earn given the current market realities?
The same thing goes for property flipping. If you purchase this property and remodel it, what is the probability that the market will be interested in paying for it? Is the market in the situation where someone would need this property so much as to pay the price that will make sense for you.
And if there is demand, what price could you expect to get?
In essence, good market analysis is considering whether “the project is viable and that it fits in the existing market,” as QuestionPro, an online survey company, puts it.
Learning how to do a market analysis for commercial real estate is foundational to investment success. You can proceed at two levels:
First, you can consider macro economic metrics (fundamentals) like income per capita, average purchasing power, job growth, demographic features, population growth, diversity of local economy, employment trends, etc., to understand the general economic condition and what the future looks like.
Second, consider the real estate market trends in particular, looking at demand and supply conditions, identifying where there is excess demand (investment opportunities) or excess supply (saturation), and taking note of how the market is currently valuing different kinds of properties.
If the market can support the vision you have for a property, the next step is to consider if the property itself can support the vision.
In essence, the question here is whether the property of choice can be improved or remodeled to become what you have in mind.
The size of the lot is one of the considerations. If you want to turn a property into a restaurant, for example, then you need it to have a reasonably-sized parking space.
What the immediate environment looks and sounds like is also important. You don’t want to have an office space in a noisy environment or an inaccessible neighborhood, for example. Neither do you want a multifamily home near a manufacturing plant.
Similarly, if the existing property type is a one-story building and what you desire is a two-storey building, you need to consider if the property can safely be remodeled accordingly.
On the legal side of things, you want to be sure that the zoning laws will allow the desired remodeling. Consequently, you will need to visit the government department or agency in charge of zoning and entitlement to confirm.
A fit-for-use analysis will often require the services of experts (builders, architects) for maximum effectiveness.
Site analysis must go beyond the current conditions of the property.
Site analysis “isn’t isolated to the current physical condition and its surroundings, but also any relevant historical information about what the site looked like,” according to Project Manager, a project management tech firm.
“You’ll want to see if there were any significant changes to the landscape and/or architecture of the site including what around the site is being analyzed,” they continued.
Internally, historical analysis can help you identify what needs to be changed during the improvement or remodeling process. For example, you can check how long the HVAC system has been functioning to see if they need a complete overhaul.
Historical analysis can also yield some important information that can feed into the market analysis.
For instance, if the property was initially a restaurant but was purchased and turned into a supermarket, you might want to ask why the original owner sold or remodeled it.
Was it because this particular location wasn’t good for a restaurant? If that were the reason, has there been enough changes in market conditions for you to go on and situate a restaurant there?
This is often called due diligence.
To conduct due diligence, “prospective buyers must scrupulously examine zoning restrictions, potential liens, and possible encroachments on the property. Existing structures must be fully inspected to discern needed repairs and their costs,” according to Wolters Kluver, an information services company.
This step might even be the most important of the commercial real estate investment analysis process. Why? You can lose your money even if you purchased property that the seller did not have a right to sell in the first place.
Consequently, it is preferable to hire a real estate lawyer who can do proper title search, examine history of ownership, and certify that the seller has a right to sell.
Now we have come to what many consider the crux of the matter: property valuation.
Valuation is last on this list by design. If you think buying the property does not make sense after doing any of the analyses above, then there might be no point even considering valuation (unless you believe that taking the risk is worthwhile if the property is cheap enough.)
The first concern here is determining an appropriate price for the property. There are two methods you can apply:
This popular rule states that commercial real estate investors should not pay more than 70% of the after-repair value of the property minus rehab costs (as shown in the chart below).
The after-repair value is how much you expect the property to be worth after you have done all repairs and improvements (more on that below). Rehab costs are the costs of every necessary repair and improvement that will bring the property to its desired state (what we called your vision for the property).
For example, if ARV is $10,000,000 and repair costs are $1,000,000, you should not buy the property for more than $6,000,000 [(70%*$10,000,000) - $1,000,000].
This method puts the maximum offer price as the difference between the ARV and the fixed costs, rehab costs, and a desired profit margin.
ARV and rehab costs are the same here as under the 70% rule.
Fixed costs represent those costs you will pay from the period you purchase the property until you sell it or get a tenant. They include agency fees, insurance, taxes, etc.
The desired profit margin is a percentage of the ARV that you want to keep as profit.
Let’s illustrate this with an instance.
Assume that the ARV of a property is $20,000,000 and that it will cost $1,000,000 to bring it to a desired state. Let’s also suppose that fixed costs will add up to $500,000 and the desired profit margin is 10%.
The maximum allowable offer will be $16,500,000 [$20,000,000 - $1,000,000 - $500,000 - $2,000,000 (10%*20,000,000)].
There are three ways you can estimate the ARV of a property. Which one you will choose will depend on your investment strategy:
WIth this approach, the ARV (market value) of a property depends on the sales prices of comparable properties in the market.
Comparable here refers to properties that currently look like what the property in view will look like after you have done all repairs and improvements.
It is better to consider many comparable properties and find an average value instead of choosing only one.
Also, you might have to do a downward or upward adjustment (as shown below) to arrive at ARV depending on how well you think the comparable properties compare to what your property will be like after repairs.
Source: Research Gate
It might be better to outsource this process to real estate professionals called appraisers if you don’t have the time or skills to do it well.
The sales comparison approach is appropriate for those doing commercial real estate analysis with the intention of flipping the property for a profit.
For those holding on for rental income, the income approach is appropriate.
Here, you will need to estimate yearly rental income and operating expenses (money spent on property management). You can use average values from comparable properties. The rental income minus the operating expenses equal the net operating income (NOI).
From the formula for capitalization rate (shown below), we can derive the ARV of a property as the NOI divided by the cap rate.
The cap rate is the yearly yield or return on investment in the property. By choosing a rate of return on investment, you can arrive at an ARV. It’s best to select a cap rate that is realistic. Consequently, you should consider what the average cap rate is for comparable properties in the particular market.
Let’s consider an example:
Suppose that the expected NOI for a property is $750,000 and the average cap rate for comparable properties is 10%. The ARV will be $7,500,000.
This is similar to the income approach (and is therefore appropriate for CRE investors holding on for rental income).
Here, the focus is on the annual gross income rather than the net operating income. From the GRM formula below, we see that we can find the ARV as the GRM multiplied by the annual gross income.
Source: WallStreet Prep
The Gross Rent Multiplier typically ranges from 4-7, according to Rocket Mortgage, a real estate company. Find the average value for comparable properties in the commercial real estate market of choice and multiply it by your estimated annual gross income.
If we assume a GRM of 5 and a gross rental income of $750,000, then the ARV of the property is $3,750,000.
Once you have completed the commercial real estate analysis and are satisfied with a property, the next step is to make a purchase.
In today’s real estate industry, you will need to pay earnest money (soft deposit) before you can even inspect a property or negotiate with property owners.
If you are expecting to finance the purchase of the property with a mortgage deal, then you might not have the necessary cash flow to pay for earnest money, thereby denying yourself access to choice real estate assets.
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