Valuing Commercial Properties | Brokers Round Table

In this conversation, we will explore the key aspects of the commercial real estate valuation process, methodologies, and real-world experiences. You'll learn about the main factors that brokers consider when assessing the value of a commercial property, such as location, property condition, tenant quality, lease terms, market trends, and potential for appreciation. By the end of the conversation, you will have a comprehensive understanding of how commercial real estate brokers approach property valuation, the key metrics and factors they consider, and the strategies they employ to overcome challenges and deliver reliable valuations.

Key Takeaways:

• Commercial property valuation involves considering many factors beyond just the cap rate, including rent roll, tenant credit, market trends, population growth, and development costs.

• Filling information gaps through networking and direct communication is crucial, as data sources like CoStar may not always be accurate or complete.

• Sudden changes in the market, like interest rate spikes, can significantly impact property valuations and require frequent re-evaluation.

• Diversifying risk by having multiple tenants in a property is important, rather than relying on a single large tenant.

• Experienced investors who have been through real estate cycles are valuable, as they can better anticipate and manage risks.

Check out CRE Central: www.crecentral.com

About Your Host:

Tyler Cauble, Founder & President of The Cauble Group, is a commercial real estate developer and investor based in East Nashville. He’s the best selling author of Open for Business: The Insider’s Guide to Leasing Commercial Real Estate and has focused his career on serving commercial real estate investors.

Episode Transcript:

0:00

Are you looking to take the next step toward investing in commercial real estate but don't know where to go? Series central offers a comprehensive education and coaching platform designed to help you get started. Our online courses cover a wide range of topics, from the fundamentals to advanced strategies, ensuring you have the knowledge and skills needed to thrive in this competitive industry. As a member, you'll gain access to our exclusive online community and monthly group coaching calls, providing you with valuable networking opportunities and personalized guidance from experienced professionals. Whether you're a beginner or looking to take your career to the next level, cre Central has the resources you need, visit www dot cre central.com. To learn more. Welcome back to the commercial real estate investor podcast. We are alive with another brokers roundtable excited to be diving into today's topic, valuing commercial properties. That is a question that I'm sure the all four of us get asked all the time, how do you actually do this, because it is a it's very different from residential real estate, you can't just go find, you know, five, three bedroom, two bath cops on, you know, three streets over and really evaluate the commercial real estate that way, it gets very specific in different ways. So that's what we're gonna be diving into today. I'm going to kick it off with you know, Adam, what are the main factors that you consider when you're assessing the value of a commercial property? And and how do you weigh the importance of each factor.

Speaker 1 1:30

So that's never black and white. When it comes to retail, there's a few main things that that we look at, obviously, we look at the rent roll, we look at the credit associated with the rent roll, we look at, you know, the potential of what people are paying now versus what we think they should be paying, we look at at very more art versus science things like Is there enough parking? What's the available signage that you can get versus the market? Is there potentially something that's grandfathered in, that the person down the street couldn't have? So obviously, we're looking at Cap rates, we're looking at credit, like, Yes, I'm gonna get really excited if there's a, you know, a national doc in a box in a bank, and, you know, a national credit tenant. But some, some things get lost if the Senator is big enough, that's all there is. So there's, there's also, there's also room to go in and find some more Mom and Pop tenants that you that you like and that and that you relate to and that you think has some staying power that can be associated with that. So not it not as straightforward as probably the industrial or office team. But but that that's some of the main factors that we look at. Yeah,

Tyler Cauble 2:47

that's awesome. Jesse, you're you're in a unique spot, right, because you do office and multifamily. So can you tell me, you know how you you adjust your valuation approach for different commercial properties? Like how different are those two?

Speaker 2 3:02

Yeah, there? Yeah, I guess they couldn't be more different in the world of commercial real estate. I mean, there's a lot of similarities, obviously, with valuation of any real estate, but I guess you could start with multifamily multifamily for us. And I'll keep this broad because there's some different things that we look at in. In Canada, that would be more similar to say New York State, Illinois, California, when it comes to being able to have tenants basically get the markets up to market rents. But for us occupancy rates obviously are a factor when it's when it comes to, to the valuation of multifamily, the rental income, not surprisingly, operating expenses, those are things that I think they're all fairly similar. I think where they do differ is the kind of market dynamics population growth, when it comes to multifamily is a bigger factor, as opposed to the economic base and the economic activities when it comes to offices. So for us with offices, it's again, income is still important, but we're looking at income and a little bit of a different way. We're looking at the underlying underlying credit worthiness of tenants. So if you look at your average office building in a downtown area, we want to just because something says 95% or 98% occupied doesn't necessarily mean that you have a solid tenant base. And we saw that a little bit with we work in it back in the day where the cap rates were a little bit higher because of the uncertainty in the beginning of coworking or at least beginning of popular coworking. So there's, there's a little bit of a difference there. It's a little bit more corporate when it comes to looking at the underlining companies, what's their credit worthiness, what's their ability to pay. And the other thing just briefly on that is the, what we call an expiry profile. If there are 30 office tenants in a building and they're all fixed, firing in the same year, just like we're talking about in the news, a bunch of real estate debt coming due in 2025 and 2026. That's not a great risk scenario. So some landlords are prudent about having expiry profiles that are staggered, so that you have space coming back. And you can handle that and being able to release it. So yeah, that's kind of a brief comparison of some of the factors. Yes, it's interesting how different each of these asset classes can really be. And it's important to take those nuances into consideration. Chet, you know, when a lot of investors are acquiring these assets, they're looking at snapshot,

Tyler Cauble 5:38

investment metrics, right? They want to see what the cash on cash return is today. But we all know that that is not the most important piece or the only factor of buying commercial property. So when you're looking at these assets, how do you determine a property's potential for appreciation? You know, like what economic demographic or market trends are you taking into consideration when you are determining potential future values?

Speaker 3 6:04

Great question. And I'll speak to it primarily through an industrial lens. But I think and you guys can agree or disagree that it's applicable across other asset classes, I think the number one driver is population growth. And you could just see that in any market in North America, presumably, the world that's had population growth has been a great market to be investing in. And the opposite of that, if you look at some markets that have had out migration or decline in population, those markets have probably struggled. So that's the number one metric for me population growth, then you can start even diving a little bit closer in and say, how quickly can you inventory be added. So there's, there's a big difference between a market like New York or Los Angeles, which has physical constraints, preventing development in those markets, you might be able to only develop in one direction. And there might even be impediments in that regard. Vancouver, in Canada is a good example, you're pretty much surrounded by the ocean and mountains, it's very hard to add any new property in Vancouver in general, you compare that to a market like Dallas or Phoenix, where you can theoretically grow in every single direction, there is no physical constraint on development. So the next thing that I would look at is, if there is no physical constraint, and you can grow in every direction, what is the cost to build new product. And once you have that number, what's the delta. So if you're buying just using arbitrary numbers, if you're buying something at $150, a square foot, and it costs $150, a square foot to build, you might not have a layer of insulation in there, things go wrong. But if you buy at $150 a foot and it's $300, to build, all of a sudden, you've got a reasonably reasonable amount of comfort in there that if the market does soften your lease got a little bit of a buffer in there. But that's those are the two main things that I'd look for in any market. Are the people moving there? Does that growth scene sustainable for the foreseeable future? And what is what are the impediments to build? And if there are no impediments? What does it cost to build and then compare those costs to the cost basis that you're going into that?

Tyler Cauble 8:11

Yeah, population growth is such an important factor. I mean, you look at what's been going on in the United States since COVID, there's been this flock to the southeastern US. And the reason that those cities are so popular is because there's so many people moving their investors are they feel very secure buying in those markets, because population is continuing to grow, which means people are going to be spending money in those markets. And it's kind of tough to see going anywhere else. I will not buy personally, in a city that has negative population growth. Agree? Yeah, yeah, it's just it's too risky. You don't know where it's gonna go. Jessie, we're gonna love this one back over to you, you know, cap rates, capitalization rates are the most probably the most popular way of determining a commercial real estate investment, properties valuation. You know, that's very different from the residential market. Where do those numbers come from, though? Like, how do you determine what is the appropriate cap rate to place on any specific property?

Speaker 2 9:11

Yeah, I think we're a lot of people get kind of, they get caught up on cap rates, just because we talked about them so often. But you know, if in its absolute most simplest way, when we're talking about a market cap rate, like we can have the you know, property value, which is equal to the net operating income divided by the cap rate. So the actual formula for doing that you can do that on a property right? If you have all those variables, you can do it on a particular property. But what we typically mean by a market cap rate is that we look in the past we look at trades that have happened, and we basically come up with a market cap rate for that area. Now it's very limited, or it's just one factor when we're looking at valuation because for instance, if we have and we've talked about this on the show before, if we have a building that is completely vacant, there's no noi so there's no There's no way to have a cap rate and we're not, you know, that mathematical equation equation is going to be undefined. And, you know, it doesn't make sense to say the property's worth nothing or worth undefined. So what we typically will do on on properties that have, say below market vacancy, or above market vacancies that will usually look at where, say it's a vacant building, for instance, we'll assume whatever the market vacancy is, and then be able to derive the income based on the market rents in the area. But you're right, it's a cap rate can be affected by a number of different things, like I was talking about before, when there's a risk analysis, some properties are seen or areas that are more risky than others. We talked about population growth, you know, the, the way that you would apply a cap rate, if you're a lender in Buffalo is going to be very different to how you're going to do it in New York. So I think when people talk about cap rates, I don't think that they should just get hung up on that one metric by you know, taking the net operating in, excuse me, the net operating income and dividing it by what they think the value is, I think you have to look more at what is your debt? What is your risks, look at other factors? Because the cap rate, again, is just it's just one metric among a number of metrics that you can use when assessing a property.

Tyler Cauble 11:23

Yeah, it gets so nuanced. I mean, that's that's the interesting thing about it. It's it's an art and a science right there. It's not like there's one black or white answer to anything. I mean, if you look at two identical assets that are across the street from each other, same square footage, same type of tenant, doesn't matter, everything's exactly identical, they can have two very different cap rates, because one is on the going to work side, and one is on the going home side. Right. And so people are going to look at that very differently, depending on what type of business is going in there.

Speaker 2 11:54

And, and I will just add on that, too. Is it on your example, two different buildings, if if the NOI is is identical, but one of the retailers is, you know, a karate studio that's been around for two years, and the other retailer is Starbucks? Yeah, technically, the cap rates the same day, I know why is the same. But those are very two different risk profiles that you need to factor in. And that's just kind of an easy example of how, you know, to 7%. Cap rates don't don't can be very different in actuality. Yeah,

Tyler Cauble 12:27

that's exactly right.

Speaker 1 12:28

But those who are different Starbucks are going to have a go dark claws and threshold claw. I might take the freaking karate studio. Just kidding.

Speaker 4 12:40

I was gonna say I might actually be the riskier profile there. Yeah,

Speaker 2 12:44

if they read the rebrand as Brazilian jujitsu? I think we have. We've got we might have something there. Yeah.

Unknown Speaker 12:51

Absolutely crushed it.

Tyler Cauble 12:54

That's funny. Well, look, I mean, to the last couple of years, interest rates have have skyrocketed, which has changed the valuation of commercial properties. Right. So I mean, Chad, you know, how often are you going back and and revisiting and adjusting cap rates and valuations? And what other market indicators do you use aside from interest rates? So you could talk about that to, to, you know, really inform these updates?

Speaker 3 13:20

Yeah, it's topical. Right now, with the interest rate environment we've been through in the last two years. I would say that, anytime there's significant movement in the Feds rate, you should probably reassess where Cap rates are. They don't move in lockstep, though, install, like we see a tuner base point increase in interest rates, and that reflects into a 200 basis point increase in cap rates. It's not it, they don't move at the same speed. But there definitely is a relationship there. So if, as an investor, as and I actually did an analysis on this not too long ago, looking at just how changes in interest rates affect the cap rate work required to meet DSCR requirements. That's kind of a mouthful there to say. But that is a term if, if you have interest rates at a certain amount, and your DSCR debt service coverage ratio was one point to call it. And that that means that there's a cap rate required to meet that threshold, as interest rates go up. So do the cap rates in order to meet those DSCR requirements. So there is there is a connection there, but it's not neat, and it's not instantaneous. And that's what I've found is that there's been a delay, with interest rates going up for people actually adjusting in their mind. And that's I bet all four of us would agree there's sellers or owners out there that still have early 2022 pricing in their mind, they still feel that that's what their property is worth when in reality. Interest rates have caused upward pressure on cap rates. In my mind, I would think were one to 150 basis. 100 250 basis points up From where we were early 2020, to late 2021. So I think that that's probably the biggest variable, then there's all sorts of other things that go into it and macro trends, even in an election year can cause people to reassess what's happening. Because so much geopolitical risk right now. Oil uncertainty, there's just so many factors right now that I've found that in 20 years, this is probably the hardest time to just stick your wet finger in the air and get a gauge on where Cap rates are. Some there's private money out there right now that's fine with cash, they might justify a lower cap rate if they're just parking money. Or if they feel that there's upside where they can increase their top line revenue and adjust the metrics that way. And then there's even someone like myself, where I'm actively looking for properties, I need a pretty high cap rate to justify it in my own mind. So I'm much more of a conservative investor. So long, long answer short, it's, it's tricky. It's tricky. If someone can definitively tell me what the cap rates are right now. I'm all yours.

Tyler Cauble 16:04

Yeah, I mean, it's, unfortunately, it's not clean. You know, we're looking at a deal right now would never have come up, had interest rates not spiked, and it's a 9.2% cap rate sale leaseback 10 year brand new lease, absolutely not deal. And I'm like, Man, that's great. The problem is like, that's kind of the same yield that I would have gotten a few years ago at a 7% cap rate, I get almost ends up being identical. So it's not like we're getting a screaming deal, just because we're getting a 9.2% cap rate today, hopefully in the future interest rates come down, and then we're able to actually realize that that arbitrage that difference between the two, but you know, we'll see that's just kind of where the market is today. Adam, you mentioned, you mentioned earlier, we were talking about, you know, Starbucks and and Brazilian Jiu Jitsu and the different risk profiles between those tenants. I mean, how do you assess the risk profile of a commercial property? You know, when you're looking at a cap rate? How did you determine that Starbucks? And this BJJ studio might both be worth a 7% cap rate? Or how would you evaluate them otherwise?

Speaker 1 17:10

Yeah, there's so many, I want to I want to narrow down a little bit. So we can talk about different types of retail. Retail that I love is just your standard strip mall, you know, 10,000 15,000 square foot type deal that these are, these are terrific deals, and you don't have to have a Wharton MBA to understand them. So the risk profile there, we'd like to say that you want to balance rich and cool. And what we mean by that is, it is nice to have the urgent care with the big medical flag behind you or the Starbucks or the the bank, the institution that you can kind of hang your hat on, like these guys are going to pay the rent, or they're going to pay me something stupid to get out of the rent. But but if you just have, you know, medical, and then financial, there's no cool factor there. So it is nice to mix in some interesting uses, along with the with the more institutional safe uses. So those are a couple of things that I always look for. And a couple of things that we we touched on earlier in the call, obviously, we have some other really smart real estate people on you want to look at those trends. You want to look at the population growth. But obviously you want to look at the income growth as well. And understand what is does this center want to be a high end center? Or does this center want to have your, you know, simple neighborhood services, like your laundromat, and just the basic thing that anybody needs? So kind of matching the rent profile and the tenant profile and the merchandising mix to the demographics around it, making sure that you're paying attention to the trend, like are you getting, if you're going into more of like a big box type setup, you have to be really damn certain that you're buying in the right area with the right trends, because what you don't want to do is put a lot of eggs in a couple bigger boxes, and then have them move to the next interstate stop that's getting built down the street where Whole Foods just got announced and everybody follows that right. So I being a simple buyer that buys on my own balance sheet. I would like to buy the more simple strip center that has multiple users that diversifies my risk a little bit like a Walgreens goes out. And if that's your only tenant, you got big boy problems. Whereas if you've got six or eight tenants over 15 20,000 square feet, you know it's not going to sink the ship. So, watching those trends, watching the demographic changes I'm trying to try to figure it out to my to my Canadian and northeastern friends where the puck is going right? Say I got, you know, Stanley Cup playoffs, I know you guys are all pumped up, try to understand where the puck is going from, from the from the trend standpoint. And then what I what I said before, this doesn't show up on a spreadsheet, but, you know, how's the signage, how's the parking, you know, if you're tucked into a neighborhood and Your Neighborhood Services Center, you know that it's going to be really, really hard for somebody to come in across the street and build a competitive center to yours. So maybe you can get more aggressive on the cap rate, because you think you can grow that grow that rent roll, when you start to get turns. So again, I could sit and talk about this stuff for the next hour and stuff on everybody else's toes on the call. But that's just a taste of, of, you know, some of the things I look at when I'm looking at a

Tyler Cauble 20:51

deal. Yeah, that's, that's a great philosophy and a great way to approach it. Yeah. Speaking of which, Chad, you've got to be fired up, man. I mean, the Oilers, making it as far as they have. Oh, that's awesome. Big.

Speaker 3 21:02

It's it's huge. The city's going crazy right now. Did you guys see the fan? The famous fan? No, what happened? There is a girl at the last game who flashed the whole arena. And she she was a she's a pretty girl. So she's gone. Kind of famous. She's probably the most famous person in Edmonton right now.

Speaker 4 21:23

That's hilarious. Oh, man, that's one way to get attention.

Speaker 3 21:27

She did it. She has an only fans account, but good for her. Naturally,

Unknown Speaker 21:31

she does marketing. We'll keep it with you, man. I

Tyler Cauble 21:37

mean, it's, it's always fun to talk theory at a high level application of how this stuff works. But like, let's get into the weeds and start talking about some examples of doing some of these valuations. So walk us through a recent property. You know, that you've you've done an evaluation on and let's talk about any unique challenges or considerations you had to have going through that process?

Speaker 3 21:58

Yeah, there's one that comes to mind right away, and it was decent sized property that we just sold. So it was the owner that built it, built it specifically for his company 15 years ago or so. And he ended up selling his company kept the building and leased the essentially leased the back to the new owners. And he had an appraisal done on it a while ago that came in about $10 million dollars. Interestingly, he it costs him about $13 million to build. So this was, again 15 years ago or so called buys it for builds it for 13 million is all in cost, then gets then sells the business, new business gets in appraised primarily at at $10 million. That was based on that company paying them rent. So from an appraisal standpoint, you know, there's the income valuation, there's the cost approach, and then there's sales comparison approach. They they weighed heavily on the income approach to value and in that case, the company subsequently ended up moving. So now we were looking at it on a complete empty bases. So it's difficult to apply income metrics, because as Jesse said, You got to start all of a sudden start making a bunch of assumptions. What's the tenant going to pay? How long is the lease term going to be? What's the covenant of the tenant? How long is going to take what T eyes do you have to do? Does that have a lot of assumptions you have to do? So in that case, it was pretty much just a sales comparison, what what similar with similar properties have sold in the region. And then what's currently being marketed, it almost comes down to being a very simple residential model of an appraisal, no different than a residential agent would do. It just happens to involve a large industrial building versus a single family home. But that's how we did that. And I came in less I came in recognizing that interest rate environment has changed and the market has changed, the appraisal was done pre interest rates spike, and we ended up coming in and I said that it should have been around eight and a half million, and ended up selling for 8 million. So that's it, you've got a really ebb and flow with with the market. And in this case, the market just changed significantly in a short period of time. So he had an appraiser, an appraisal done, which probably cost a few grand, and you'd think that you could rely on that. Well, I'm sure even the appraiser would have come back and said yes, the markets changed. Here's the new revised price. So I think it's that's one of the main values that a broker can bring to the table is using real time data as opposed to relying on something that might have sold six months or a year ago. It's having that pulse on the market and being able to respond quickly, especially in an environment where things are changing so quickly, which where we find ourselves right now.

Tyler Cauble 24:43

Man, that's a great example. We'll have to do a case study on that sometime because everybody's so used to seeing their property appraising for higher and higher valuations. And that's that's not always the case. I mean, it's you know, if your depends on the market and and you know where we are, but we'd love to dive in that further with you some time, Adam, you know, we don't always have all of the data as we're going into evaluating these properties, right? Whether that's, you know, something that we just can't get a hold of costars wanting us to pay for it, or the owner just does not have it somehow. What do you do when you're in a situation like that? You've got to fill those information gaps.

Speaker 1 25:21

Yeah. I love this question, because it's the most boring answer ever. But it's always true. Right? The data in the retail world is typically garbage. And the in the data is almost never correct. And costar, no offense, I love giving you 55 grand this year costar, you really appreciate you guys. But the retail world it's typically not right. In addition to that, you have to go out and knock on doors and have an extremely good network because everybody knows now and maybe not everybody knows. But it is it is well known now that a lot of anchors outside of your typical big box, you know, grocery anchored or a big box anchored centers is f&b. The only way to understand if your f&b tenants are doing well is to get your ass in the door and start to talk to people and have an extremely good network that you can lean on to really get a sense of what's going on in the street. So if anybody believes a costar rent roll, and a costar market set comp, when you're when you're buying a retail property, I love it because I want to compete against you. Right, you have got to be able to wear out some shoe leather, or in today's world where we all wear, you know, casual sneakers, I guess to rubber, and go out and shake some bushes and understand what is going on on the street. Or you're going to get your lunch eaten. So it is a super boring answer. But you've got to get in the car, you've got to go talk to people. And you have to maintain an incredible, incredible network of brokers that you can trust and operators that you can trust. I'm way more likely to call operators of restaurants than I than I am. Other brokers because those guys know everything. You want to get good data at f&b, go sit at the bar somewhere. Be nice to your bartender. And you can get more data than you get on costar. So super boring answer. But I've found it's correct. 10 times out of 10 to go get in the car and talk to people.

Tyler Cauble 27:40

Yeah, I tell new brokers that all the time. Look, this business is not you know, there's not some like crazy secret out there. You just got to be the guy that's willing to get out from behind your computer and go talk to people get on site, because so many brokers today want to be lazy. They want to depend on costar, they want to depend on this data they've got without verifying anything. And nine times out of 10 It's not right. So don't do that. Jesse, have you had any deals that really surprised you or deviated from your initial expectations? And what were your key takeaways moving forward? on evaluating properties after that?

Speaker 2 28:16

Yeah, no, nothing like that over the last five years. Yeah, the big one. The big one for us. I mean, I've talked about it briefly before but you know, it's it's not surprising was interest rate, interest rate changes, it was one of those things that, you know, for the rest of my investing and real estate career, I will remember because it was just such a black swan event for interest rates to go from two 3% You know, all the way to say floating debt at 10% plus. So for for us a we underwrote a building that either way, we were going to need some floating debt, for construction, that was going to be a part of the deal. And we did our sensitivity analysis, and we thought it was pretty conservative. And we're like, you know, if rates go up this far, and, and it's not like we didn't expect questions on that from our LPs, we did expect questions on how conservatives is the underwriting. You know, but but now we're talking about should it be 567 percent. And you know, at the time, if we all remember, like, that's insane. That's never, it's never gonna get there at a percent or two, I guess, as the delta between most us at the time and versus Canada. But that was something for us that going forward. Just just being mindful of the things that you can't control and figuring out how to de risk those type of deals and you can't control the interest rate environment, but you can control how much leverage you have that's affected by interest rate changes. So that's probably the big one that that for, you know, for years. I'd never understood some of the older guys in our office or older investors I've talked to where they they just won't feel calm. trouble having a GP that hasn't been through some sort of real estate crisis or downturn in a cycle and you really start understanding the logic behind that once you've seen spikes that that you just could not predict it, or very, very few people could.

Tyler Cauble 30:14

That's so true. You've got to go through the cycles. It was so frustrating always hearing that as a younger broker, younger investor. You know, we want somebody with gray hair that has seen it up and and downside goal. And I was like, yeah, why does it matter? I've read about it. You know, you actually do get a lot more conservative after you've been through that yourself. So that's, that's great advice. Guys. This was an action packed episode. I appreciate you all for joining me, Jesse. Chad. Adam, thank you all audience, go give them a follow up, their contact information is in the description. These guys are great. They've all got their own podcast as well, and are sharing a lot of phenomenal information out there. So gentlemen, thanks for joining me, and we'll see y'all here in a couple of weeks. So fellas, thanks. Are you looking to take the next step toward investing in commercial real estate but don't know where to go? Series central offers a comprehensive education and coaching platform designed to help you get started. Our online courses cover a wide range of topics from the fundamentals to advanced strategies, ensuring you have the knowledge and skills needed to thrive in this competitive industry. As a member, you'll gain access to our exclusive online community and monthly group coaching calls, providing you with valuable networking opportunities and personalized guidance from experienced professionals. Whether you're a beginner or looking to take your career to the next level. Care Central has the resources you need. Visit www dot cre central.com To learn more