Commercial vs Residential Real Estate - How are they valued?
Multi-Family vs. Single Family – is there a difference in how we can determine the value? Short answer, YES! Let's dive in.
One of the primary benefits of investing in large multi-family apartment communities is the ability to force appreciation through improving the Net Operating Income (NOI). Let’s dive in and take a look at how this is an advantage over residential real estate.
First, let’s define the difference between commercial and residential real estate, with a focus on apartments. Residential real estate is classified as 1-4 units, meaning a single-family home up to a 4-plex. Commercial real estate is defined as 5+ units.
For residential real estate, the most often used valuation is the comparative value approach, which is simply comparing your properties against others in the area. If your neighbor’s house sold for $250,000, assuming yours is similar in square footage, beds, baths, etc. you can expect yours to trade right around the $250,000 mark. It may not matter that you have granite countertops and nice vinyl plank flooring and your neighbor didn’t, your house is going to be roughly the same value as theirs.
Now let’s look at the valuation model on commercial real estate, which is based primarily on the income the asset generates more than what others in the area have bought and sold their properties for. As owners of commercial real estate, this gives us more control in driving the value. If I can increase the net operating income (revenues minus expenses) from when I bought it, my asset is worth more.
Commercial real estate is valued by the following equation: Net Operating Income / Cap Rate = Value
For example, let’s say we bought a 200 unit apartment building with a value add business strategy. The current NOI at acquisition was $600,000. We paid $10,000,000 for the building since we knew the going cap rate for this area and a building in this condition was 6%.
Through our value-add business plan, we found a way to increase rents and even decrease expenses through some operational efficiencies. We were able to raise the NOI by $50,000 in the first year. What does that do to our valuation?
$650,000 (NOI) / 6% (cap rate) = $10,833,333.33
In one year, we created $833,333.33 in additional equity for our investors simply by improving the NOI. BOOM!
It doesn’t necessarily matter what the apartment complex across the street is worth, we can quickly determine what the approximate value of our asset is based on an easy calculation.
In conclusion, I hope this brief article helps explain the difference between residential and commercial real estate when it comes to valuation. As an owner of commercial real estate, the ball is in your hands. You have the ability to control the NOI, and therefore control the value.
That is powerful.