What is the "Right Price" on Commercial Properties

Volume 5 Number 7 March 4, 2007

What is the “Right” Price on Commercial Properties? And other comments...
Last week one of my clients told me that he would like to raise some cash to pay his impending federal tax bill. He owns quite a few properties – most are income producing, some land, some warehouses, some offices - and all very marketable. This gentleman is a very logical seller (and logical buyer, for that matter). He knows what motivates him so he knows what motivates buyers. He keeps detailed records, copies of invoices, leases, and tax records, etc. When he tells me the net operating income, I know the number will be accurate.
We did a full analysis of his portfolio and put two of his commercial income properties on the market.
In the commercial real estate market savvy investors use a capitalization rate (Cap Rate) to do an acid test of a properties worth. Put simply, the cap rate is a measure of the return a property’s net operating income will generate as a percentage of its cost. A property that generates $100,000 worth of income from rents after paying for all expenses to own and manage the property, but before paying debt service would sell at a $1,000,000 price if the cap rate was 10%. ($100,000/10%=$1,000,000) Buyers prospecting for good properties are looking for cap rates of around 7 to 8% these days; some times less from properties with very long leases and with AAA tenants; and sometimes higher CAP rates from older properties with shorter leases. If a property has a net operating income of $100,000 and a buyer is willing to accept, say a 7% CAP rate he would pay $1,428,571 for the property. ($100,000/7%). If on the other hand he needed to get an 8% CAP rate he would pay only $1.250,00; at 9% the price would have to would be $1,111,111. ($100,000/9%)
When I started buying commercial income properties in Fort Myers, I remember telling the agent that I did not buy by cap rate. This was because that most cap rates advertised were bogus.(Unfortunately this is still often the case) The agents or sellers often fail to include many
expenses in their pro-formas (a pro-forma is a reconstructed Profit and Loss statement) that needed to be there – such as reserves for long term replacement items such as driveways and roofs; they may leave off vacancy and credit losses; and they may forget to include management fees. Because of these omissions in many pro-formas, as well as the difficulty and inaccuracy of getting accurate lease and expense information, many commercial buyers will make an offer at a given CAP rate. Then during the due diligence period will make every effort to discover what the true net operating income is. Most commercial offers are contingent on a 30 to 90 day due diligence period during which the buyer will have inspections and audits completed.
The two properties we put on the market can be viewed by clicking here or (www.ma-realty.com) and going to the commercial section.
One reason a buyer will pay a price that offers a lower CAP rate for a property is for it’s upside potential. If the price per square foot for example is well below replacement cost, or the rents are well below market, or major repairs have been made on key items like roofs and air-conditioning; the buyer may have reason to believe that he can soon lift the cap rate by increasing rents or lowering operating expenses. A good agent will take all this into consideration when advising a buyer client on how to make his offer and a seller client what price to ask
The price a seller asks is also guided a great deal by his motivation. In my client’s case for example, he needs to sell one of his properties at a CAP rate attractive to the buyer in order to effect a rapid closing to raise cash to pay his taxes. (He is also not bashful about letting the buyers know this either). In fact, I have been telling prospects that once one of the properties is under solid contract, the other properties from this client will see either a removal from market or a price increase. Why? Because his motivation has changed.
So what is the right price to pay for a commercial property? Today we just talked about CAP rates. The right price to pay is the price that will give you the return on your investment that will satisfy both your short terms objectives and long range goals. We must take into consideration your cost of money and your opportunity cost (What else you could do with that money)
If your cost of money is 9% would it make sense to buy a property with a 7% CAP rate? Yes, but only IF there was a good prospect for increasing the CAP rate in the short and long term, there is a good future property appreciation anticipated (CAP rates ignore appreciation), or the investment met other objectives. A good commercial agent will help you analyze the income, the appreciation, and the tax benefits of ownership, along with your attorney and tax advisors.
If you have what I call “very patient money” and are able to ride out cycles that are inevitable in our market, you may be willing to buy at a low cap rate because the investment simply beats out other things you could do with your money.
If you need a competent commercial property advisor, email me, I just might know one or two!

Let me talk a little about residential pricing. Last week I mentioned that, in general, we are at the bottom of our price cycle. I also said that real estate has low price elasticity of demand. I got many emails in agreement and a few in disagreement. (Article Here)
I have had an interesting experience since last week. As some of you may know we lowered a few or the Citadel Condo offerings (www.citadel-bonita.com) to as low as $178,000. Keep in mind our last sale was at $259,000. I received four phone calls on this just yesterday. Three of them were questions about “What was wrong with the property? Why so low?” (Some times you can’t win!)
Quite simply, there is nothing wrong with the property; and yes we have condos in Bonita as low as $178,000. (We are still shooting for an average sellout price well above this number.) But a lower price will not necessarily give you a quick sale. There is a perception that a $178,000 condo is, well, inferior to one that is priced at $230,000. (It’s the same condo) Price is just part of the package however, and we need to do some buyer education as well. Make comparisons, do a feature analysis, etc. There are condos today priced in a very wide range – some times for the same floor plan in the same building. Get your agent to actually look at all the condos you may be interested in, regardless of price. You never know your sellers motivation and how keen it may be.
Also remember, when savvy buyers see a price decrease, they wait for another one. When they see an increase, they buy.

I met with a developer for Breakfast on Saturday morning. We met to discuss a potential new project for 90 condominiums in Bonita. We talked about land cost per door, features of the project, and what we thought would be a realistic selling price. Kind of hard to answer that question isn’t it; when condos are not selling even at fire sale prices? This developer needs the presales in order to get his financing. For this reason alone, I don’t think the project will happen.
The canceling of projects is a good thing for the market, bad for the developer. Keep in mind that costs of construction are still high and the prices that sellers are seeking for their land are high. This means to me that condos that are built now will be a better deal than condos available in the future. Thinking of buying? Buy now. Prices will go up. I
Many buyers are waiting to see prices start going up. The trouble is, by then it may be too late. When buyers see a drop in price, they wait for another one. When they see an increase, they assume there will be another one and start buying. This may be a mistake. My suggestion is to go into the market with a professional agent and start making offers.
The more time I spend showing our new project Parkside at Rivers IV to end users, the more convinced I am that buyers today don’t want promises but want delivery all at once. They want the neighborhood, the water, the parks, the boat slips, and they want no construction around. They want it now, not, “Some Day”. I have asked Christopher at Devious to build the advertising campaign around that theme – “Buy where it is”; “Buy a Floor, Not a Floorplan, etc.) See www.deviouslycreative.com.

I am writing this while cruising along Continental Airlines to San Francisco Sunday afternoon. I will be attending a Fractional Ownership conference there. I have been investigating fractional ownership for Florida Real Estate for a few years now. I believe the time has come to bring these concepts to Lee and Collier Counties. Why buy a million dollar condo that you only use for two months a year if you could get the same thing for one fourth the price? More to follow on this from me, be sure.
I am going out there to learn the pros and cons – but I have done some research and I am certain you will see some additional fractional opportunities in town. I will be sitting down with Tom Goetschius, an expert in the field (See his article here) as well as the many of the pioneers in this business. Stay Tuned.

Market America is looking for experienced Residential and Commercial agents. If you are experienced and you believe, like I do, that long term relationship selling is the key to success, please contact me for a confidential interview.
We are also interviewing buyer and sellers. If you have a property you would like us to value, please contact us. We need quality commercial properties to offer and developer projects that need the kind of visionary selling Market America excels at.
We are target marketers, by the way. When we get a new listing it is presented to the entire team and then we determine who would be the best buyer for that property. We then go find him. Marketing real estate today, be it commercial or residential, takes hard work, experience, and a great deal of product knowledge. It also takes patience.
Whether you are buying or selling, please give us a try.
If you have missed past emails you can search here: ARCHIVES
Gregg Fous
Gregg@ma-realty.com
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