If you ask several financial professionals about owning commercial real estate or even just owning your own building as a small business owner, some will think it is a great idea and others will think it is a terrible idea.
Remarkably, few of them will even stop to help you consider the specifics of your situation with the property. They either like or dislike owning your own place of business as an abstract idea. But, as with most of wealth management, there is a price at which buying a building is a great deal and a price at which you would do better by not purchasing the property.
Here is a simple way to think about commercial property.
On average, the value of real estate appreciates by inflation. Some real estate in areas growing in popularity appreciates by more than inflation on account of its location. Other areas which fall out of favor fail to keep up with inflation. For our formula, we will assume that real estate appreciates by inflation.
On average, stocks appreciate 6.5% over inflation and bonds earn 3% over inflation. Average returns in real estate fall between these two numbers. When commercial real estate earns above inflation, it earns about 4.9% over inflation. Residential real estate earns 4.1% over inflation. These numbers can be used to help determine if a real estate purchase is a good financial investment.
For commercial real estate to earn 4.9% over inflation, you need to earn a net profit of 4.9% of the purchase price of the real estate each year.
Net profit is computed by taking the annual rental income and subtracting the total cost of owning and operating the building. Costs consist both of normal operating expenses as well as upkeep and maintenance of the building.
Getting estimates from the current owner is the best method of approximating operating costs. Many office buildings include all of the utilities and amenities in the price of the rent. Others charge less but require tenants to pay their own share of the utilities. Operating expenses may include the following: property taxes, cleaning, gas and electric, landscaping, insurance, accounting, snow removal, water, trash removal, licenses and permits.
Maintenance is often more difficult to estimate. Some buildings have deferred maintenance and need hundreds of thousands of dollars of work before the property can be rented. Estimating ongoing expenses can also be difficult because years can go by before major repairs need to be made.
For maintenance which has been deferred and needs to be done, add the estimated cost of such maintenance to the cost of purchasing the building. Count all the deferred maintenance costs toward the cost of acquiring a building in a decent condition.
Ongoing maintenance is often about 1% of the cost of acquiring the building without counting the cost of the land. Maintenance costs may be lower than 1% for years until some major repair or renovation needs to be done. Then, all in one year, you may need to put on a new roof, replace half the windows, and repair the heating and cooling system.
To calculate appropriately-priced annual rental income, add 4.9% of the purchase price onto the operating expenses and maintenance. Then, take that number and divide by the square footage of the building. This price-per-square-foot is what you would quote to renters, so compare that to what others are charging in the area to see if it is reasonable.
For example, imagine you are thinking of buying an office building with 5,000 square feet of rentable space for $1 million. Of that price, the building is worth about $850,000 and the land is about $150,000. The building needs about $100,000 of repairs.
The cost of the building would be $1.1 million (purchase price plus repairs) and the annual maintenance would be approximately $8,500. Imagine you have calculated the additional total operating expenses to be $30,000.
In order for the profit to be $53,900 (4.9% of the cost of the building), the total rent would have be $92,400 per year. At that amount, the rent per square foot is $18.48. Using comparable rents in the area you can judge if that rent suggests the price of the building is high or low.
Using this formula, you can also work backwards. If rents in the area are only $17 per square foot, then you should only offer about $850,000 for the building instead of $1 million. At that price, profit from rent would be 4.9% of the total cost of the building plus renovations.
Computing the value of commercial real estate should be done assuming that you will be paying cash for the property without including mortgage calculations. Mortgages for commercial real estate should be considered separately.
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