A Few Basics
The first question is: Just what is Commercial Real Estate? The next question is, what is Investment Real Estate? Sometimes they are the same and sometimes they are not.

Commercial real estate is generally defined as any property that is used for the purpose of commerce. For example, an office building, a warehouse, retail store, shopping center or an apartment building with five or more units. Investment real estate is generally defined as property that is purchased for the income it produces. This can range from the purchase of a single-family home that is used as a rental, to a major shopping mall or office tower. It does not include the home you own and occupy.

While the valuation of a single family home is most often established by the sales of comparable homes in the same area, larger commercial property is usually valued by the income it produces. The more money it makes, the more it is worth. Simple, right? Well, sort of. Let’s start with an explanation of the general process of real estate valuation.
Keep in mind that what an appraiser says is defined as “an opinion of value based on supportable evidence and approved methods.” It is important to understand that the appraiser does not establish a property’s worth but rather verifies what the market indicates.

There are three processes of valuation an appraiser will use to determine the value of any piece of real estate. These three processes are:

Cost – The cost to build a similar piece of real estate.

Market – Based on the closed sales of similar properties in similar condition and areas. This is called the comparable or market value.

Income - The property value based on the net operating income the property produces. An appraiser will use all three processes, but select only the one (or, at most two) that most accurately reflects the market value. They are never averaged.

As an investor in real estate, you will be particularly interested in the Net Operating Income (NOI) in order to determine a property’s worth to you.

Here is an easy way to compute the Net Operating Income:

Start with the total income that would be generated if the property is fully occupied. Then subtract any money lost due to vacancies, uncollected rents or other credit losses. The remainder constitutes the money available to operate the property. From this figure, subtract all operating expenses, such as routine maintenance and property taxes.

What is left is called the Net Operating Income (NOI). Simple. Straightforward. Easy to understand.

In the next article, I’ll discuss the significance of the NOI and introduce you to the shirt tail cousins, CAP rates and
Gross Rent Multipliers.

Please note that the numbers used here are for illustration only, and are not at all reflective of any current market.