Residential Vs. Commercial - Value Creation

A good agent and investor who mainly operated in residential properties (1-4 units) mentioned to me that the one thing he liked about residential real estate was that he could create value with "emotions." During the moment it sounded like some platitude about residential real estate but, then it hit me. He was right! It made me think of the differences between how value can be created in commercial versus residential real estate.

With residential real estate, you can create value or raise price only to a certain extent as much as can be justified by an appraisal because a lender will only lend upon a percentage of the appraised value or the contracted price (whichever is lower).

The amount of value creation in residential that I've seen has varied from 5 up to 15% max above the recently sold comparables in the area. I think it can be difficult as a residential appraiser who inspects and has to document, explain, and justify why his/her opinion of value will be worth the additional 5-15% in price with respect to the other surrounding properties.

If the reasons for the higher value cant be found (view, culdesac, floor plan, lot, use, zoning, etc) the value will not be justified so its a gamble or an artful exercise.  The problem with creating value with residential is that a lot of the factors are subjective till there are proven comparables that have sold and "show," what an improvement is "valued," at. For instance if a property sold for 110k instead of 100k and the only difference was the pool then an appraiser's inclination is that the pool is valued in this market at 10k (all else equal) so a good agent who can utilize this information may be able to win a "listing," with a willing buyer off this premise, however there is no guarantee that an appraiser will accept this either as there may be other countering information in that particular market.

The advantage of commercial or multi-family is that value creation range or limit is nearly uncapped since its based on a multiple of NOI (net operating income). The value creation is also much easier and definitively documented via income and financials and less about subjective comparable market analysis that may vary from party to party since these types of properties are purchased for income.

If the property's NOI is increased by either increasing income or reducing expenses the value of the property can rise in multiples of this number.

Example:

Buying a property at 8% Cap Rate based on 75,000 = $937,500

Increase NOI to 95,000 at 8% Cap Rate, new value 1,187,500

Value creation of 250,000 by creating 20k more net annual income which is about 1666.67 per month net income increase

There will sometimes be a difference between appraisal value (market value) and lenders value for the property, but as long as the value and consistency of the income can be documented "to be likely to continue," going forward then the value can be used. A secondary plan to avoid having to bring in more down payment is request to see if the seller will carry the difference so a larger down payment is not needed to acquire the property.