{"id":25862,"date":"2012-02-02T11:30:50","date_gmt":"2012-02-02T18:30:50","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=25862"},"modified":"2023-07-10T10:39:17","modified_gmt":"2023-07-10T16:39:17","slug":"2012-02-02-investment-property-valuation-residential-vs-commercial","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2012-02-02-investment-property-valuation-residential-vs-commercial","title":{"rendered":"Investment Property Valuation: Residential vs Commercial"},"content":{"rendered":"

A man and his realtor walk down the street and the man says \u201cRealtor, I want to buy that house,\u201d pointing to a beautiful 3 bedroom 2 bath home, \u201cWhat should I offer?\u201d\u00a0The realtor responds, \u201cWell, I\u2019ve looked at the comparable sales in the neighborhood and it looks like another 3 bedroom, 2 bathroom home sold for $100,000 just last month.\u00a0I would offer them $100,000.\u201d\u00a0The man agrees and buys the home.<\/p>\n

The next week, the same man comes back up to his realtor and says \u201cRealtor, I love my new home, but I had a great year at work and have some extra money that I want to invest.\u00a0I heard that the retail center up the street is for sale.\u00a0I saw the one across the street just sold for $500,000 and was identical.\u00a0Should I offer $500,000?\u201d\u00a0The realtor responds, \u201cLet me check the sale price.\u201d\u00a0The realtor makes a few calls and comes back to tell the man the news. \u201cWell,\u201d says the man, \u201cCan I buy it?\u201d\u00a0The realtor then tells the man the news, \u201cThat retail center is for sale for $1,000,000.\u00a0Maybe we should look at something else?\u201d\u00a0\u00a0 The man, looking confused, thinks for a minute and then says, \u201chow could that be? They are identical in size and just across the street.\u00a0Why is that one worth twice as much?\u201d<\/p>\n

We\u2019ll get back to the realtor\u2019s answer in just a minute.<\/p>\n

Before we answer his question, let\u2019s take a quick look at how property values are determined.<\/p>\n

Let\u2019s first take a look at residential properties.<\/strong><\/p>\n

There are many types of residential real estate<\/a>, in this article we will define residential properties as single family homes. Homes are traditionally purchased as a place to live by their owner. They can also be purchased as rental properties. But, because the percentage of homes purchased as rentals is relatively small when compared to the single family home market as a whole, their valuation is based on the same methods.<\/p>\n

Home prices are determined by using a few different comparable sale methods.\u00a0These comparable sale methods are done by using cost per square foot, cost of construction, or floor plans. \u00a0\u00a0These valuation methods are also applied for duplexes and four-plexes.<\/p>\n

For instance, let\u2019s say a home sells in your neighborhood for $100,000.\u00a0It has 2 bedroom and 1.5 baths.\u00a0It is similar in style and size to your home.\u00a0When you go to sell your home, the realtor will probably tell you that it is worth $100,000 after looking at the comparable sale.<\/p>\n

Determining residential home value is straightforward and relatively easy to do.\u00a0You look at similar homes and what they sold for, then adjust for any differences, and you can quickly determine the value.<\/p>\n

Commercial real estate is different.<\/h3>\n

We define commercial real estate as properties that produce income.\u00a0They consist of apartment complexes of 12 units or more, or office, retail, and industrial buildings.\u00a0These buildings are primarily owned by investors.\u00a0These investors do not live there, but rent them out to tenants who pay rent each month for their space.<\/p>\n

Commercial real estate value is determined by the income it generates.\u00a0\u00a0Income is calculated by taking the rental income and subtracting out the operating expenses.\u00a0You do not factor in loan payments or income taxes.\u00a0The amount that is left is called the Net Operating Income.<\/p>\n

If you want to invest in commercial real estate, you must know how to calculate the Net Operating Income<\/a>.<\/p>\n

Commercial property value is determined by how much an investor is willing to pay for the Net Operating Income.\u00a0The investor trades their investment dollars for the property\u2019s income.\u00a0The rate that the income pays back to the investor for their investment is called the return on investment.\u00a0The sales price is determined by how much the investor is willing to pay for projected Net Operating Income.<\/p>\n

Value = Net Operating Income\/Desired Return<\/p>\n

Let\u2019s look at a quick example.<\/p>\n

Let\u2019s say that an investor is considering purchasing a retail center or apartment complex that has a Net Operating Income of $100,000.\u00a0In that area, investors are willing to buy properties like this for a 10% return on investment.<\/p>\n

In this case, the property would be worth $1,000,000.\u00a0The value is determined by taking the Net Operating Income divided by the desired return on investment ($100,000\/10%= $1,000,000) for investors in your area.\u00a0This means if an investor were to invest $1,000,000, he would expect to receive a 10% return on his investment each year ($100,000).<\/p>\n

Now that you know how values are determined, let\u2019s get back to the realtor\u2019s answer to the investor\u2019s question on how the two property\u2019s values could be so different.<\/p>\n

\u201cThe reason,\u201d the realtor answered, \u201cis because this property has better tenants and generates more income than the one across the street.\u201d<\/em><\/strong><\/p>\n

What the investor initially failed to see is that he wasn\u2019t just investing in the buildings as you do in residential real estate.\u00a0The buildings were identical.\u00a0He was actually investing in the tenants, the leases, and income that is generated by them, not the buildings themselves.\u00a0Once he realized that, he looked again and it was easy to see why the values were different.<\/p>\n

When he looked again, he noticed that the second building had higher quality tenants, a thriving restaurant, and was obviously doing more sales. \u201cOh, I see\u2026 because that retail center does more in sales, it can charge more for rent.\u00a0When it does, it produces more income. Right?\u201d<\/p>\n

\u201cYes\u201d said the realtor.\u00a0\u201cWhy don\u2019t we go grab some lunch and we can talk about locating the right property for you?\u201d<\/p>\n","protected":false},"excerpt":{"rendered":"

A man and his realtor walk down the street and the man says \u201cRealtor, I want to buy that house,\u201d pointing to a beautiful 3 bedroom 2 bath home, \u201cWhat […]<\/p>\n","protected":false},"author":659,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[5527],"tags":[1585,3988,3989,59,3987,3985,3986],"class_list":["post-25862","post","type-post","status-publish","format-standard","hentry","category-commercial-real-estate-investing","tag-commercial-real-estate-investing","tag-commercial-real-estate-value","tag-determining-value","tag-real-estate-investing","tag-real-estate-valuation","tag-single-family-vs-commercial","tag-single-family-vs-multifamily"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/25862","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/659"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=25862"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/25862\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=25862"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=25862"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=25862"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}