This post originally appeared on tBL member Allen C. Buchanan's blog Location Advice and is republished with permission. Find out how to syndicate your content with theBrokerList.
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As we’ve discussed – commercial real estate is owned by those who occupy it with a business or investors who rely upon the rent the property produces. Therefore – a slice of commercial real estate is valued according to its utility – in the instance of an occupant or to an investor – in its ability to produce income. Occasionally the lines cross – which I will cover in the last section.
Utility varies. Think about it this way. If you’re a company that tools aerospace parts – the electricity feeding a property is critical because you use it in your operation. Without the amperage – the parcel is worthless to you. A logistics company that stacks products in a warehouse relies upon the number of truck doors and inside ceiling height. Therefore – utility is found in a property with such upgrades. An easy way to consider utility? Generally, an occupant considering a selection of buildings will place a greater emphasis on utility or use in its decision. Said occupant is willing to pay more if the commercial real estate has the features he seeks.
Income production. Rent. How much? How certain? How long? Easy. Let’s assume a building has market rents and is leased to a Fortune 500 tenant for ten years. So, there is very little risk. The valuation is simple – an investor will buy the income stream for a price. His price? Easy math. Annual rent divided by his desired return – also knows as a capitalization or “cap” rate. Thus, an annual lease payment of $12.00 at a 6% return yields a value of $200 per square foot. Consequently – your 20,000 square foot building is worth $4,000,000.
If a building is vacant – is it of no value to an investor? If he is smart – certainly not! However, the analysis is more complex and the stars must align for the resulting price he can pay to compare to an occupant purchase. Here’s the way it works. Since an investor relies upon the income – rents – a property produces, he must calculate what those rents will be, how long it will take to achieve them, and at what cost. We refer to this as lease origination expense. If he’s looking at a vacant building and the seller wants $200 per square foot – the investor must factor in the origination expense. If an investor can pay the $200, absorb the origination expense, and still get his return – golden!
If a property is leased – is it worthless to an occupant? It depends. Keep in mind – an occupant looks at utility. And he must be able to occupy the building. So, if the PERFECT site – with all the bells and whistles – is available but leased for awhile – it might still work. Here is how. We recently represented a buyer. Obligated for two years in a lease – they wanted to pursue a purchase for their next move. So, if we located a building for sale with a short term lease in place – that was beneficial. We did! Plus. Because the lease on the building we bought was short term – the buyer got a better price. Because – most investors were turned off by the impending lease expiration and most occupants couldn’t wait two years to move. Boom!
When do the lines cross. We are seeing a fair number of investors buying vacant buildings these days. Recently – a high percentage of the structures in a new development in north Orange County were sold to investors – vacant! Their motivation? Money needed to be spent. Capital had to be deployed. It was costlier to wait than to buy vacant and incur the origination expense. A similar trend is occurring inland where new logistics boxes are trading without tenants in place. The reason? More occupants are seeking leases vs purchases. As an investor – if you can buy the right utility – your origination costs are reduced, you create the income, and the world is a happy place.