Will Your Residential Experience Transfer To Commercial Real Estate Investment?
If you have some experience investing in residential real estate, how much of your knowledge applies to investing in commercial real estate? Unfortunately, probably not very much. Your knowledge of financing terms and of some general real estate terms will be helpful. But beyond that, it's like comparing apples to oranges. Without getting too complex, let's take a look at the major differences.
The value of residential real estate is usually determined when a buyer and seller agree upon a price based on comparing the recent sales prices of other nearby properties with similar characteristics. For instance, the selling price of a three bedroom two bath house with no upgrades will usually be within 1% to 2% of other similar three bedroom two bath houses in the neighborhood. This is called the sales comparison approach, and it's the standard method that buyers and sellers use to determine value for single-family properties.
For commercial real estate, the standard method for determining value is to measure and compare cash flows. Of course, the physical characteristics of a commercial property are valued as assets on the owner's business balance sheet. But the primary method of deciding on a purchase price for commercial property is to compare its cash flow with the cash flow of other investment opportunities.
This unit of measurement is called Net Operating Income, or NOI. It's calculated by subtracting operating expenses from operating income. The rate of return that the investor wants to make on his money will determine the amount that he's willing to pay for the cash flow.
For example, if an office building has a net operating income of $50,000 per year, and the investor needs to make a 10% return on his money, he would be willing to pay $500,000 for the property.
The investor would be comparing the purchase of the office building with other opportunities to make a 10% or higher return. If he could purchase a $60,000 per year cash flow for that same $500,000 he would make a 12% return on his investment.
In that case, of course, he would buy the apartment building instead of the office building because he's comparing cash flows. Notice that he's not concerned that one is an apartment building and one is an office building. His investment goal is to get the highest Return On Investment, or ROI for the $500,000 that he's spending.
With residential real estate, the value lies in the physical assets of the building and the land that it sits on. Additional value is created through making improvements to the property and through appreciation, if and when that occurs. With commercial real estate, the value lies in its cash flows, which can be increased either by decreasing expenses or by increasing rents.
Investing in residential real estate is like being able to drive a car. Investing in commercial real estate is like being able to drive an 18 wheeler. They're very different vehicles.
About the Author:
Author and entrepreneur Bernz Jayma P. is the owner of a financial blog dedicated to helping people expand their knowledge on personal finance. You may visit his blog at http://www.Invesmint.com.