With single-family homes, determining property value proves fairly straightforward – just look at market comps. But, what about a commercial property with no similar buildings in the area? How can investors accurately estimate value for these unique properties? To determine the value of commercial properties, investors use an *income-*based approach – not market comps. More precisely, the commercial value formula provides investors a reliable – and consistent – method to value dissimilar commercial properties.

As such, we’ll use this article to outline how the commercial value formula works and, more importantly, how investors can use it to their advantage. Specifically, we’ll cover the following topics:

- An Overview of the Commercial Value Formula
- The Numerator Approach: Increasing Value with NOI
- The Denominator Approach: Increasing Value with Stability
- Final Thoughts

**An Overview of the Commercial Value Formula**

When a neighborhood has hundreds of similar, single-family homes, appraisers and investors can easily establish market value. You just need to find several comparable homes – or “comps” – that recently sold, and those prices determine value.

But, most commercial real estate lacks both this uniformity and volume. There just aren’t enough comparable commercial properties to use a market comp approach to valuation. Instead, appraisers and investors use an income-based approach. More precisely, parties use a mathematical formula – the commercial value formula – to determine value. According to this formula:

*Property Value = NOI / Cap Rate*

NOI, or net operating income, equals a property’s rental revenue minus all operating expenses (NOTE: mortgage interest and depreciation are *not *operating expenses). Due to NOI’s role in the commercial value formula, this valuation technique is commonly referred to as the *income* approach.

Conceptually, capitalization, or cap, rate equals the return a property would generate on an all-cash (i.e. unleveraged) deal. For instance, if you bought an apartment building for $1,000,000 cash and it generated operating income of $50,000, it would have a 5% cap rate. Mathematically:

*Cap Rate = NOI / Property Value*

As this rearranged formula illustrates, cap rates depend upon two interrelated factors: a property’s operating income and its value. More precisely, cap rate hinges on a property’s risk and stability. If a property generates stable, reliable income, investors will pay a premium, which increases value and creates a lower cap rate. Conversely, unreliable income creates more risk for investors, lowering the property’s value and increasing its cap rate.

Understanding the commercial value formula – and its associated elements – arms investors with two key tools. First, this formula provides *a *method (but not the only method) for comparing otherwise dissimilar commercial properties. Second, breaking down the formula into its numerator and denominator provides investors opportunities to *increase* a property’s value (and, by extension, investor equity), which we’ll discuss in the next two sections.

**The Numerator Approach: Increasing Value with NOI**

Once again, the commercial value formula states:

*Property Value = NOI / Cap Rate*

Looking at this mathematically, investors have two options for increasing a property’s value: 1) increase NOI, and/or 2) decrease cap rate. Let’s start with the *numerator *approach.

Assume an apartment building has a 5% cap rate. After analyzing rents and expenses, you find a way to increase monthly NOI by $5/month for a total of $60. As a result, you increase the property’s value by $1,200 ($60 NOI increase / 5% cap rate) – not bad.

Now, let’s look at a more real-world example. Say that you purchase an office building with a 5% cap rate for $2,000,000 with an 80% LTV mortgage.

*Initial Value*: $2,000,000*Initial NOI*: $100,000 ($2,000,000 value x 5% cap rate)*Initial Equity*: $400,000 ($2,000,000 value – $1,600,000 mortgage)

After the purchase, you invest another $200,000 cash into improving the building’s common areas and HVAC systems, which lets you increase tenant rents and decrease operating expenses. These improvements generate a 20% NOI increase.

*New NOI*: $120,000 ($100,000 initial NOI increased by 20%)

*New Value*: $2,400,000 ($120,000 new NOI / 5% cap rate)

*New Equity*: $800,000 ($2,400,000 value – $1,600,000 mortgage)

For an additional capital contribution of $200,000, you increased NOI, and the property’s value jumped by $400,000. In other words, for $600,000 cash ($400,000 down payment plus $200,000 in capital improvements), you gained $800,000 in equity and control of a $2,400,000 commercial property generating an NOI of $120,000!

**The Denominator Approach: Increasing Value with Stability**

Investors can also increase a commercial property’s value with a denominator approach, that is, a reduction in cap rate. To reiterate, the more stable and reliable a property’s income, the lower the cap rate. Conversely, high vacancy rates and unreliable tenants add significant risk to a property’s income, which drives cap rates higher.

Understanding this relationship between risk and cap rate provides investors another path to improving value. That is, if you can improve the reliability of a property’s income, you can decrease the associated cap rate – boosting value in the process.

Let’s continue the above example. Assume that, after making the common area and HVAC improvements and negotiating new rents, you also changed the lease durations from year-to-year to five-year terms. By locking tenants into five-year leases, you’ve decreased the likelihood of vacancies and improved the reliability of your income. In the local market, office buildings with similar characteristics, tenants, and lease terms command a 4% cap rate – not your original 5% cap rate at purchase.

With this lower cap rate, you end up with the following numbers:

*New NOI*: $120,000 ($100,000 initial NOI increased by 20%)

*New Value*: $3,000,000 ($120,000 new NOI / 4% new cap rate)

*New Equity*: $1,400,000 ($3,000,000 value – $1,600,000 mortgage)

Now, your $600,000 cash investment has resulted in *$1,400,000* in equity and control of a *$3,000,000 *commercial property!

**Final Thoughts **

To be clear, the above numbers represent basic – and hypothetical – situations. But, the important takeaway for investors is the outsized impact seemingly small changes in a property’s NOI or cap rate can have on value. Especially when you combine these two elements, the commercial value formula provides investors an incredible tool for forcing property appreciation.

If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available investment opportunities – and how you can leverage the commercial value formula with them.