When it comes to adding value to commercial real estate, the concept can be confusing. What does it really mean to add value? To add value means to increase the value of the asset beyond what it costs you to build or to improve the asset. If you spend ten thousand dollars making an improvement to a property and it increases the value of the property by ten thousand dollars, you have not added value beyond what it cost you to make the change. The property might look better, but if it doesn’t increase the value it’s hard to justify making the change from a return on investment perspective.
Adding value means you spend ten thousand dollars making an improvement to a property and it increases the value of the asset by fifteen thousand dollars. Now you’ve added value to the property. It’s worth more than the amount of money you spent to make the change.
Adding value to commercial real estate is more difficult than adding value to residential real estate. When it comes to adding value to residential real estate, it’s fairly easy to add value simply by remodeling the home. Many fix-and-flip investors add value to a residential investment simply by making some cosmetic changes to the home like adding a fresh coat of paint or improving the landscaping or replacing the carpet and installing new appliances in the kitchen.
These approaches work with residential projects because homebuyers are generally less sophisticated when it comes to value. They base their decision of whether or not they want to purchase a particular home primarily on how they feel about the property or whether or not they can afford the cost.
Making cosmetic changes to a commercial real estate property are often less convincing to savvy real estate investors when it comes to adding value. Most commercial real estate investors focus on income rather than cosmetic improvements. If the income doesn’t go up, the value doesn’t go up.
When we’re talking about income, the overriding metric used in commercial real estate is Net Operating Income. Net Operating Income (NOI) is Effective Gross Income minus Operating Expenses. Effective Gross income is Gross Rental Income plus miscellaneous income minus any vacancy. Operating Expenses include all expenses from operations but excludes any interest expense paid on the mortgage or any depreciation attributable to the property. The NOI and Operating Expenses are always calculated on an annual basis.
Principal payments on the mortgage are not considered Operating Expenses but are rather reductions in the outstanding mortgage balance. Principal payments don’t even show up on the Income Statement which is also called the Profit and Loss Statement. They show up on the property’s Balance Sheet.
Once you have calculated the Net Operating Income for a property, you apply what’s called a Capitalization Rate to determine the property’s value. The Capitalization Rate or Cap Rate is basically the expected yield on the property assuming there is no debt.
The formula for calculating the value of an income-producing property is as follows:
I / R = V
Some call this the “IRV” formula, where “I” equals Net Operating Income, “R” equals the capitalization rate and “V” equals the value. Using this formula, you would need to know the NOI and the Cap Rate of a particular property type to calculate the value of a specific property.
Experienced commercial real estate advisors know the cap rates of various property types. They establish these rates by collecting market data on a number of sales of a particular property type. The “IRV” formula can be written another way to compute the cap rate for property types:
I / V = R
Once you know the standard cap rate range for a particular commercial property type, you can apply that rate to determine the value of a particular property. These rates vary depending on the perceived risk of a certain class of properties. For instance, a free-standing retail property without a major national credit tenant would have a higher cap rate than one with a national credit tenant. The better the tenant, the lower the cap rate. Walgreen’s, for instance, would have a lower cap rate than a mom and pop pharmacy.
So, if you want to add value to a commercial real estate property, there are three things you can do: (1) Increase the Effective Gross Income which increases the Net Operating Income; (2) Decrease the Operating Expenses, which increases the Net Operating Income; or (3) Develop a new property and tackle the risk of going through the rent stabilization phase.
If you buy an existing income-producing commercial property, one of the easiest ways to increase its value is to find ways to make the property more attractive to a prospective tenant so they will pay a higher rental rate. The higher the rate, the more income, the more income, the higher the value. Making the property more attractive can be done by upgrading both the interior and exterior of the property. You can also improve the signage to make the property more appealing.
Another way to increase the income is to add more rentable square footage to the property. This obviously increases the income, but can be tricky because you don’t want to spend more on the renovation or upgrade than the increase in value you achieve from the improvement. Since you’ve already purchased the land, which becomes a sunk cost, adding additional rentable square footage should add value to the property.
Using the “IRV” formula, it’s fairly easy to determine whether the increase in value is worth the cost. Here’s an example of how that would work.
Say the Net Operating Income of the property is currently $50,000 and the Cap Rate is 7.0 percent. The Value would be $714,286 or approximately $714,000 ($50,000 ÷ .07 = $714,286). If you were averaging $15 per square foot in rents on an annual basis and you added 500 additional square feet, you could expect an additional $7,500 per year in rental income, assuming you had no vacancy or Operating Expenses attributable to the space.
That increased rental income would increase the value by $107,143 ($7,500 ÷ .07 = $107,143). If the cost to add the space is less than $107,143 which equates to $214 per square foot ($107,143 ÷ 500 sf = $214.29 psf) it might make sense to construct the addition. You add value when the cost of the improvement is less than the increase in value that occurs once the improvement has been made.
Looking at it from an Operating Expense perspective, if you can decrease the Operating Expenses, you can also increase the value of the property. Say the Effective Gross Income was $95,000 and the Operating Expenses were $45,000. Given the same NOI of $50,000 and Cap Rate of 7 percent, the value would be $714,286 as shown above.
Now, if the annual Operating Expenses were decreased by $5,000, the value would increase from $714,286 to $785,714 ($55,000 ÷ .07 = $785,714). So for every dollar Operating Expenses were decreased value increased by $14.29 ($785,714 – $714,286 = $71,428 ÷ 5,000 = $14.29). Reducing Operating Expenses is the most cost effective way to increase value as long as the reduction in Operating Expenses does not harm the property by causing deferred maintenance.
The third way to add value to a property is to build new. This assumes that the cost to construct new is less than the value after rent stabilization. For example, we’re building a new self-storage facility. The overall cost to construct the project is $6,000,000, which includes all the costs, both construction costs (hard costs) and development, financing and carrying costs (soft costs).
When the project is completed and fully rented to the market occupancy level of 94 percent, which will take about two years, the Net Operating Income from the property is expected to be $490,000 which, at a 7 percent cap rate, gives a value of $7,000,000 ($490,000 ÷ .07 = $7,000,000). That’s a million-dollar increase in value over two years! Based on an equity investment of $1,500,000 and a loan of $4,500,000 for a $6,000,000 self-storage project, that represents an annual return on investment of 33.3 percent, excluding any cash flow or principal pay-down. Now that’s a strong increase in value!
From my perspective, in order of priority, the single most effective way to add value in commercial real estate is to build new, if you don’t already have an existing building you’re dealing with. It takes a lot of work, but it’s worth it if you have the patience and can handle the risk through development, construction and rent stabilization. The second most effective way to increase value, if you’re dealing with an existing building is by reducing Operating Expenses, if you can do so without harming the property. When you’re purchasing an existing commercial property, you have to be extremely careful that the seller didn’t just stop maintaining the property so he could reduce his operating expenses and increase his NOI to sell the property for a higher price.
And, finally, the third way to increase value with an existing building is by improving the property which effectively allows you to increase rental rates or by adding additional space. Both of which increase Effective Gross Income and thereby increase Net Operating Income. Obviously, the first choice relates to newly built projects and the second and third choices relate to existing projects.
At Overland, we always try to add value to our existing properties by making strategic improvements and by reducing Operating Expenses but our preferred method of adding value is to develop, construct, and manage new properties for our clients. We’re just completing the equity raise on our second self-storage project. If you would like to discuss participating with us on a project, please give me a call at 801-231-6650 or send an email to kholman@overlandcorp.com.