To best understand the more complicated science of assessing commercial real estate value, we only need to simplify through basic and familiar example. To exemplify one of the world’s more recognizable brands, a great quote that comes to mind. The quote coincides with one of the most clever business models in the last century, from none other than McDonald’s fast food restaurants. Although McDonald’s is associated with hamburgers, and originating the concept of ‘fast food’, its founder Ray Kroc often reminded people of the big picture. “Ladies and gentlemen, I’m not in the hamburger business. My business is real estate,” he told a group of MBA students in 1974.
Happy Meals or Corner Lots?
It might be surprising to anyone hearing that for the first time. However, if you stop and think about almost any McDonald’s in the Phoenix area, or the 2-3 locations nearest to your residence, it starts to make sense. Think like this: location, location, location. McDonald’s restaurants dominate the prime commercial real estate landscape. This is hardly a coincidence either. Early on, as McDonald’s expanded by selling franchise rights to other business owners, the McDonald’s company still struggled financially overall. Eventually, Kroc and other execs realized the potential for immediate and long term financial leverage by way of investing in commercial properties suitable for operating fast food restaurants. Essentially, McDonald’s as a corporate entity was buying up prime commercial properties, and then by leasing back the purchased buildings at lucrative premium lease rate. This is the ideal investment scenario for any commercial property investor. Although some franchise owners complained of the high lease prices charged by its own parent company, the locations of a great majority of these buildings always justified the high lease rates.
McDonald’s: We’re not buying good food; we’re buying convenience and presence
McDonald’s owns the most prestigious and lucrative commercial real estate portfolio in all the world. Chances are, the McDonald’s closest to your home or workplace sits right on the corner of a busy intersection. This is the most visible, accessible, and profitable location for any food service to operate. The corner-front presence of these buildings is what drives the overall value for both the building owner (McDonald’s Corp.) as well as the renter (Mcdonald’s franchisee), as it offers the most accessibility for customers and business revenue. It also serves as high-end advertising for itself. All of this is where McDonald’s demonstrates a fundamental example in determining commercial property value: revenue potential. Revenue potential is the primary determination of overall value in commercial property. In appraisal vocabulary, this is referred to as the ‘Income Approach.’
Mo’ Money, Mo’ Revenue, Mo’ Rent = Equals Higher Commercial Value
The higher the income projection is for any particular commercial property, the higher the property value. For the sake of simplicity, let’s stick with residential rental properties. For example, with a multi-family residential property such as a four-plex or even a larger apartment complex, one of the primary factors in determining value will be rent revenue. Of course, other factors must be considered such as operating costs, repairs, vacancy, possible employees, etc. This is where due diligence is necessary for potential buyers to determine the value of an investment property.
In the event of commercial property investment—like with a McDonald’s, this is where a ‘Real estate proforma’ is commonly used to determine potential market value. The ‘proforma’ will accurately project revenue and performance of given commercial property—which at the end of the day, helps determine building value. A Real Estate proforma is simply a projection of cash flows for a commercial property over a buyer’s desired holding period. Once an accurate cash flow projection is in place, this can be calculated against operating costs and help an investor determine annual net operating income (NOI) as well as a CAP rate. Short for ‘capitalization’, this rate the projected annual income from the gross rent multiplier (GRM), divided by the current value of the property. In basic terms, think of the ‘current value’ as the purchase price ($120,000), and the GRM as the total gross rent revenue for the first 12 months
Simple Math for Simple Real Estate
So if an investor paid $120,000 for a commercial building, and the expected monthly income from rents is $1,200, the expected annual capitalization rate would show as follows: $14,400 ($1,200 x 12 months) ÷ $120,000 = .12 or 12%.
Keep in mind, investors will have different CAP rate requirements depending on the type of property, location, rent or business revenue projections, etc. Also remember this is a simplified model which leaves out interest, insurance, operating costs, and other common expenses. Commercial Real Estate Values can become much more complicated, with more considerations and risk. You should always seek input and daya from a trusted commercial real estate expert before considering any type of investment. But this paints a clearer depiction of commercial sales comps, and the factors that help establish commercial value. Commercial value is typically dependent on lease revenue for building owners, and business revenue for those looking to lease commercial space. In a business like fast food or convenient stores, location and high visibility is necessary. Based on that need, an older, 1,800 sq foot corner-front location is going have a higher market value than a brand new building or space twice the size, but tucked away in the corner of a strip mall. Since the visibility and access is limited, customer access will affect revenue, and the size or age of the building will not hold real value to a customer driven business.
You already knew the true value and secret behind McDonald’s billion dollar profit revenues was NOT the food. Did you ever realize it was all about “the business of real estate.” ?
For more information on specific commercial properties, or to find out the value of your own commercial property, contact one of our experts Bryan Watkins (bryan@LRAphx.com) or Don Mortensen (don@LRAphx.com)