Approach #3: Cost to replace the property
The third approach to figuring out what a property is worth is the cost approach, which appraisers seldom use these days. The theory behind it is this: The value of a property is whatever it costs to construct a new one in addition to the cost of the land.
To apply the cost approach in valuing a building, you must first figure out what the value of its land would be. This is typically done via a sales comparison approach (see the section “Approach #1: Comparable sales,” earlier in this chapter). Then you have to determine what it will cost to construct, reproduce, or replace the building in question as if you were doing it from scratch. Be sure to allow for accrued depreciation and obsolescence of the building.
You end up with a property value calculation of
Land value + building cost – depreciation = estimated property value
Understanding What Creates Value
What is it that really creates value in commercial real estate? Well, in residential real estate, such as single-family homes, what creates value is location. “Location, location, location!” Sound familiar? The most expensive homes are in the best of neighborhoods, right? But location isn’t the only factor that creates value in commercial real estate. In fact, two factors are actually more important than location: use and the lease. We cover these in the following sections.
Use: How the property is used gives value
How a property is used is probably the most important factor in understanding values in commercial real estate. Here’s why: Let’s say that you have a 5-acre lot directly across the street from a brand-new luxury apartment complex that has a three-month waiting list for new tenants. Common sense says that you should develop it into another apartment complex because there’s great demand. It appears big money awaits you.
But upon further research, you find out that the city says that your 5-acre lot can be used for only agricultural purposes. Where is there greater investment value — in a high-rent luxury apartment complex or a tomato farm? Unless you are also in the sauce business, the luxury apartment complex is the winner. Use determines value.
Here’s a quick example showing how use can have a significant impact on property value: Let’s say you go ahead and decide to farm and grow tomatoes on your 5 acres. You can produce a thousand 25-pound cartons of tomatoes per 5 acres. You can sell them for $2 per pound, which produces an income of $50,000. After you deduct a production cost of 30 percent, you’re left with $35,000 of income over 5 acres. So, you end up with $7,000 per acre. If you were to capitalize that at 8 percent, here’s what it would look like: $7,000 ÷ 8 percent = $87,500 per acre. And here’s how to get the estimated value over the 5 acres: 5 acres × $87,500 = $437,500.
Now, let’s say that the 5 acres was approved for use as an apartment building. On your 5-acre lot, you can fit 2 acres of living space. Each acre is 43,560 square feet. So, 2 acres equals 87,120 total square feet of living space. It’s reasonable to say that apartment sales are going for $50 per square foot. Therefore, 87,120 square feet × $50 per square foot = $4,356,000, which is the estimated value for the apartment building.
Wow, how exciting! This is what commercial real estate is all about — finding opportunity, creating a product that betters humankind, and then reaping the rewards. The challenge in front of you in this example is to get the zoning changed on the 5 acres to allow an apartment building. To find out more on zoning and land development, flip to Chapter 16.
Leases: As the lease goes, so goes the value
A lease is a written legal agreement between the lessor (the landlord) and the lessee (the tenant) whereby the lessee compensates the lessor (by paying rent) for the use of the property for a specific time period. There’s no such thing as a typical commercial lease, but here are a few main differences between a lease for a commercial property and a residential property (an apartment unit, for example):
A commercial lease is a lot tougher to get out of than a residential lease.
A commercial lease tends to last a lot longer, sometimes for 20 years.
Because no standard commercial lease exists, parties can be as flexible and creative as they want.
A commercial lease has significantly less consumer protection (for the tenant) than a residential lease does. Many tenant/landlord laws such as rent control don't apply.
As you may imagine, leases are the number-one killer of deals. They’re the lifelines of income to the property. If the lifeline is tethered and weak, then your income is weak as well. And who wants to invest big dollars in a not-so-sure income stream? The lender won’t, and you shouldn’t either. In fact, if a business in one of the shopping center’s stores has a lease agreement with one year left, the income from that store isn’t even counted by the lender when making a loan decision — maybe you shouldn’t count it in your initial analysis either.
Here’s how you, the investor, or a lender would look at a property’s lease in connection to the value it creates for the property: Say you’ve been sent a great deal from your broker. It’s for a 5,000-square-foot, single-tenant property that’s occupied by the successful family-run and family-owned Grandma’s Corner Groceries. The rent is $7 per square foot, or $35,000 per year and that includes taxes, insurance, and maintenance. The current lease has five years remaining.
Say also that you’ve been sent another deal for a 5,000-square-foot property that has a Starbucks as its tenant. Starbucks pays $6 per square foot, or $30,000 per year, which also includes taxes, insurance, and maintenance. The current lease has five years remaining.
The question is this: Which is the better investment? Grandma’s Corner Groceries or Starbucks? Which one is a lower risk? Which one allows you to predict that you’ll be paid every month for the next five years? Which one is less likely to go out of business? Which one