When considering the differences between residential and commercial real estate, one of the key attributes is the way that valuation is done for a given property. In the residential world, the value for a specific property is obtained by using comparables or comps. These are simply similar properties in the same area which have recently sold and demonstrate the price a buyer is willing to pay in that market. However, when the value of a commercial property is assessed the fundamental approach is different. A commercial property’s value is based on the net operating income (NOI) produced along with the capitalization rate (also known as cap rate) which is a measure of the rate of return that is expected to be generated from similar assets in a market. While an investor cannot change the cap rate of a property, they can change the NOI. This is done by either increasing income or decreasing expenses.
Increasing income is the most talked about method for increasing NOI. A well bought property that has below market rents is a prime candidate for adding value. That said, in a hot market it is rare to find a property where rents can be substantially increased without doing some type of improvement. Therefore, a typical value add play will consist of some type of renovations such as floors, appliances, countertops and painting which will allow for the property manager to charge higher rents. It’s important that a market analysis be done of other apartments with comparable offerings to the subject property’s post renovation offering to ensure that the rents you are trying to achieve are obtainable in that market.
On the defensive side of the NOI increase we have the properties expenses. A poorly ran property will often be bloated in their expenses in one or more areas. This offers the investor an opportunity to increase NOI by employing a more organized property manager who can follow a reasonable budget. Another common way in which expenses are decreased is conservation. Using toilets and faucets which dispense less water is a common method for decreasing water costs while more efficient HVAC and better insulation might help with electricity. What’s important in all these strategies for NOI increase is once again to perform an analysis prior to purchasing the property to understand both the costs and benefits of making these changes.
While we have only scratched the surface of ways to increase NOI in this article, it’s important to reemphasis why this is such as large opportunity in the commercial real estate industry. In a residential property if you can spend $1,200 to save $100/month it will take you a year to recuperate the cost of that improvement. Meanwhile in the commercial world not only will you save the $100/month ongoing, but you would also add $20,000 of value to the property in a market at a 6% cap rate ($1,200/0.06=$20,000). This is perhaps the most compelling reason for investing in commercial real estate and one of the reasons we believe it is a solid choice for any investor’s portfolio.
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