Or,Â how to master commercial real estate analysis.
About a week ago we ran across the above pictured stadium. If you haven’t already, take a moment to appreciate, if nothing else, the complete unexpectedness of use. If you can clear the hurdle that many us trip over immediately, in short, all that wasted square footage!, we can’t help but admire the strange and imaginative adaptive reuse of this one time baseball stadium.
There’s a reason, however, for this liberal use of space. Our gut business-minded reaction is not unfounded. These homes are in fact model homes, a development company’s cleverÂ use of otherwise short term vacant space in one of the world’s most expensive cost per area countries, Japan. Eventually these model homes were demolished and replaced by a more conventional use of commercial space, a multi-terraced commercial mall – shops, restaurants, and urban green.
We can’t deny either, this new use of spaceÂ is bizarrely beautiful in its own respect. It goes to show that a snapshot of a property as it is currently, a baseball stadium, model homes, or aÂ mall, need not determineÂ its final form.Â It’s easy enough to value a property based on its current production, but much more valuable to understand a property’s realÂ potential.
The standard method of commercial real estate property valuation is not rocket science. If a property produces a certain amount of net operating income, or income after operating expenses, we simply divide that NOI by our required rate of return, or capitalization rate, in order to find a property value.
SoÂ you’ve seen this all before. Here at REsheets, we must have used this same property value example in at least three of our blog posts already. So what’s new in this blog?
When valuing a property based on its current performance, we’re assuming what we see is what we get. This isn’t the only way. Cue: Pro Forma.
An investor hardly ever makes a decision based on current conditions alone. The inherent risk in investment is the unknown future, by definition. This is why a considerable investment in commercial property nearly never ends with a single valuation analysis based on present net operating income.
If we need to know the true potential of a property, we need to know about a plethora of real estate conditions that canÂ (and should!) changeÂ a property’s future. The capturing of these conditions is known as a Pro Forma. It’s our job to know how to master one.
Notice the upside and rollover analysisÂ page below.
Showing the annual current rent side by side with pro forma rent allows us to visualize the upside or downside of commercial space. In this example, we’ve concluded that the Coffee Shop tenant is currently 11.11% below the expected market rate for that space, and the Organic Grocery Store is overpaying 8.54% for its commercial space. The totalÂ rollover variance then, is the difference in current and pro forma rent.
So how do we decide the rent differential between current and pro forma tenants?Â Market comparables, forward market conditions, planned updates and renovations, and even the track record of a new owner are acceptable places to begin. That’s where current actual conditions end, and your expertise as an analyst begins. The more accurately you can predict the future tenant rents, expenses, vacancies (andÂ rollover rates), and the expected rate of return for future buyersÂ (reversionÂ CAPÂ rates), the moreÂ accurate you will be in understandingÂ a current property value.
How to use a real Pro Forma:
Depending on your niche in commercial real estate, the pro forma will help determine, ultimately, whether or not a property is worth pursuing, buying, or selling. If you’re a buyer, then a current listing price below your underwritten pro forma value spells opportunity. If you’re a seller, then an offer equal to, or above a pro forma value should be considered, even if your currentÂ NOI suggests a lower price. If you’re an agent, then you’re likely representing a buyer, seller, or both, and the pro forma is one of the most important tools to tell the real story your client needs to hear, in an understandable fashion.
This is where we explain that here at REsheets, we believe we have the cleanest, easiest to use, and easiest to present pro forma valuation software around. But as this is a resource blog, we’ll stop our pitch here and simply include an actual example from our Apartment Discounted Cash FlowÂ executive summary page showcasing the value of a properly produced pro forma.
With the aboveÂ displayed PGR, vacancy, concessions, other income, expenses, and even financing, we can easily assessÂ the real pro forma value of a property.