Evaluating Commercial Real Estate – Part 2

This is part two in a two-part article that delves into the process of evaluating commercial real estate. Part one covered the basics, including definitions and assessing profitability. Part two here will cover how to research commercial properties and carry out the appropriate math.

Beginning to Research

Doing research on commercial properties is a lot of work, especially figuring out the ownership structure. A great deal of commercial real estate is under private ownership, and ownership may be under a different company for each property for liability reasons. To find commercial properties, search real estate and assessor records using variations on the prospect, spouse, partner and company names. Searching all the addresses associated with the prospect, spouse, partners and their businesses can also lead to more property holdings. Googling addresses and company names is another way to find more properties, companies and partners. Setting Google alerts on a prospect and any heavily used addresses can reveal a window of opportunity for an ask. This can be akin to Alice’s adventures, as you follow the rabbit trails from one property or partner to another.

Primary owners or partners and front companies or persons usually can be found through assessor or vendor records. Sometimes sources will provide the primary mortgage amount or some refinance or equity loan amounts that reveal what the owner has invested in the property; for owners with small portfolios, the amount still owed on properties can help determine if the capacity ratings should be adjusted up or down.

Building advertisements can offer clues to help estimate lease rates since leases are not public documents. Rentable square footage or net rentable area often can be found or estimated through advertisements, property listings or assessor records. This information can be necessary for calculating capacity.

There is a lot of information that cannot be found about commercial properties: all the investors in a property; percent of partner ownership; multiple loan notes or refinances; whether a property has been used to leverage purchase of other properties;  liens against a property; and all the real estate in a portfolio. The owner’s fixed expenses (insurance, licenses, etc.), operating costs (e.g., repairs, maintenance, utilities) and other balance sheet information will remain a mystery without seeing the current year’s profit and loss statement.

What can and cannot be found impacts the ability to calculate gift capacity because some pieces of the financial puzzle are missing. There also may be other partners involved in the portfolio who are not named in public sources. Commercial real estate does not have easy liquidity of something like stock. There are more factors and a longer time frame involved in selling property to make a gift or gifting it outright.

For these reasons, I handle gift capacity based on commercial real estate assets differently and use net income, as opposed to asset value, as the basis for capacity unless the building may be directly gifted. To be sure this was an appropriate methodology, a financial advisor who was familiar with many of my prospects reviewed and validated my capacity ratings. When my ratings were off, it was because he had information I could not find publicly.

Doing the Math

The rate of return on lease rates (called cap rate), is important to estimating net income, which is the company’s ultimate bottom line profit, including all income (e.g., investment and interest income) and deducting all expenses (e.g., taxes, unusual expenses). Determining operating liabilities is impossible from public information. I use net income for the capacity calculation.

Cap rate is based on net operating income (NOI), which does not take some of the income and expenses in the net income calculation into consideration, but also depends on knowing operating expenses.

 

NOI = Total Operating Revenue - Total Operating Expenses

Cap rate = Net Operating Income (NOI) / Property Asset Value

 

Typically, there is a 4 to 5 percent cap rate in high-demand area and an 8 to 10 percent (or even higher) cap rate in low-demand areas. In general, 4 to 10 percent­­ is considered a reasonable annual ROI because real estate is a long-term investment (except if your prospect flips properties). Sellers want a high-cap rate because the property price is then high, while investors like a low-cap rate because the property price is then low. Fortunately, with a little digging, you usually can find or estimate cap rates for a particular area of town since operating expenses are not disclosed.

In addition to cap rate, revenue is needed to estimate net income. Because most commercial real estate is held privately, revenue figures are often hard to find for portfolios or individual properties. Generally, the only places to find a revenue figure are in an article, top list or a reference site like ReferenceUSA or Dun & Bradstreet.

If revenue cannot be found, it can be estimated. First, determine the usable square footage in the building. This is often available on from the assessor or on LoopNet. LoopNet is also great for finding the lease rate per square foot of the building or finding comparable properties (comps) to estimate the rate.

Once you have these figures, calculate annual revenue:

 

Usable Square Footage X Lease Rate = Gross Annual Revenue (GAR)

 

If the building’s vacancy rate can be determined, reduce revenue accordingly and factor in any other local market information. Sometimes the vacancy rate is in the leasing flyer or available spaces are listed in ads or on leasing sites. You can also Google the address with phrases like “for lease” or “now available.”

If the prospect has a huge portfolio, select one or more representative buildings from the portfolio, determine gross revenue for each representative type and multiply that times the number of similar buildings, then add up the totals to get estimated gross revenue. Once you estimate GAR, estimate net income.

 

GAR X Cap Rate = Net Income

Then use net income to calculate gift capacity:

Net Income X 2% X 5 Years = Estimated Gift Capacity

 

The 2 percent is based on my research that indicated companies that give generally can do so based on 1 to 3 percent of profit. Professional investors have a lot more assets generating revenue than dabblers, and the percent can be adjusted upward for extremely large portfolios. The investor’s lifestyle or personal assets also can indicate whether that percentage should be higher or lower.

For hobby investors, base capacity on personal assets plus revenue generated by the buildings. If there is an indication that the prospect could or would gift a building or leave it to your organization in a bequest, use asset value, not revenue, as the basis of the rating and use the standard calculations your organization uses for income/revenue and personally held assets.

When presenting the capacity rating to fundraisers, it is advisable to add qualifiers. Especially note that all the investors and all the properties in the portfolio may not have been identified and that much of your calculation is based on very educated estimates because there is a limited amount of publicly available information on private assets and liabilities.

Learning about and evaluating commercial real estate can be quite time consuming and challenging, but it is well worth the effort if your prospect portfolios are rich in such assets. Because of the time involved, full evaluation and rating based on these property holdings should only be done in preparation for an ask.

 


Christine A. Mildner, CFRE, has had a long and rewarding career in healthcare and education fundraising. Currently, she is the senior philanthropy analyst at Legacy Health in Portland, Oregon. She also is a consultant and principal of Strategic Edge Resource Consulting. She was an editor of the Internet Prospector, and has volunteered with Connections throughout her career.

Prospect Research

Want to hear more from Christine on the topic of commercial real estate? Learn about how commercial real estate owners make money, how to evaluate real estate holdings and how to rate prospects in the webinar "Evaluating and Rating Commercial Real Estate Owners."

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