Pricing Commercial Buildings I

This is an article I wrote for the July 2007 Issue of Broker Agent Magazine, North Central New Jersey Edition.
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A client calls you and says they have a 12 unit apartment building they would like to sell. You have never been involved with a commercial transaction before; you panic. What do you do? First tell them that you would love to help them and that you need to do some homework. Ask for a description of the building and say that you will call back. The most important part of making the transaction close, just like a residential deal, is pricing the property right from the get go, so potential buyers won’t be turned off.

So how do you price an apartment building? Well there are several methods. For two to four unit buildings, they are financed as residential properties, and they price the same way, by comps. Five units and above are considered “Commercial” for the purpose of financing, but buildings up to six units trade a bit like houses, so comps are still important in pricing. Over six units, buildings start pricing for their investment value, and a different approach is required.

The most important method is to price using CAPITALIZATION RATES, or “Cap Rates.” Cap Rate is defined as the rate of return used to derive the capital value of an income stream. The formula is Value = Annual Income / Cap Rate. (1) Value equals the theoretical market value of the property, and the price around which it should sell. The annual income in this case is NET OPERATING INCOME (NOI), or income minus expenses, prior to financing. The Cap Rate is expressed as a percent, usually in the range of 6% to 12%; of course deals can be priced outside this range under special or extreme circumstances.

The first step is to determine what is the correct Cap Rate to use. The best way to do that is to ask someone knowledgeable, either another agent who deals in commercial property, or better yet, a mortgage broker who deals heavily in commercial mortgages. It is important to make contact with a commercial mortgage broker, since they can help you to determine the maximum amount the bank will lend on the property, and therefore the maximum amount the property can sell for. And one will be needed during the transaction anyway.

Once you have determined a cap rate, you need to calculate the income and expenses; using Microsoft Excel is the best way. You will have to work with the owner to figure these out. First you need a rent roll. The rent roll should contain the apartment number, the size in total rooms, the current tenant name, and the current rent. For any vacant units, use the last rent, or the maximum allowable rent if the unit is rent controlled. Add all the rents up to get a total monthly figure, then multiply by 12 to get an annualized figure. Add to this any other income such as from laundry or vending. This is the TOTAL GROSS INCOME (TGI).

You will need a number for vacancy and credit loss. The bank will use 8% in their calculations, the recent nationwide average is 10%. Many brokers will use 5% or less, to make the building attractive, but a savvy buyer won’t believe it. Don’t use less than 5%. To calculate the vacancy figure, multiply TGI by the vacancy percent. Subtract the vacancy from TGI, and you get GROSS OPERATING INCOME (GOI).

Next, ask the seller for the following annual expenses: Taxes, Insurance, Utilities and Superintendent’s Compensation. You will also need a number for maintenance; since many owners may either under spend or under report this number, it is best to use an estimate such as $500 per unit per year. It is also customary to have a reserve for repairs and replacement of capital items such as the roof or boiler. $500 per unit per year is also a good number for a reserve. Now add up all the numbers to get the TOTAL OPERATING EXPENSES (TOE).

Subtract TOTAL OPERATING EXPENSES (TOE) from GROSS OPERATING INCOME (GOI) and you get NET OPERATING INCOME (NOI). Divide NOI by the Cap Rate and you get the building value.

Here’s an example. Let’s say the average rent is $750, multiply by 12 units, and the monthly rent roll is $9,000. Multiply by 12 to annualize, and you get TGI of $108,000 (this assumes no other income). For vacancy Multiply TGI by 5% and you get $5,400. $108,000 - $5,400 = $102,600. So your GOI is $102,600.

Assume the following expenses: Taxes $12,000, Insurance $6,500, Utilities $10,000, Super’s Comp. $3,600 (2), Maintenance, $6,000, Reserves $6000; TOE equals $44,100. Subtract TOE of $44,100 from GOI of $102,600 and you get NOI of $58,500.

Assuming our commercial mortgage broker recommends a 9.00% Cap Rate for the building, based on condition, area and the prevailing market, calculate the building value as NOI $58,500 / 9.00% = $650,000. You may want to add as much as 10% onto this value for “negotiation,” to get a suggested listing price range of between $699,000 and $715,000.


(1) Barron’s Dictionary of Real Estate Terms, 1993 Barron’s Educational Series, Inc.
(2) Assumes a part-time super getting a $300 a month discount off rent.