BUYING INCOME PROPERTY is different than buying a house. Home buyers make a lot of personal choices about the floor plan, the neighborhood, the school district and even the color of the carpets. But if the house goes up in value over the years, that’s a bonus.
Income property, on the other hand, is supposed to provide a return on your investment. Its worth is based on the economic principle of anticipation, which states that value is created by the expectation of future benefits. In other words, how much you pay depends on how much you expect to get back.
Income property pays you back in two ways. First, it produces rent. Second, it pays you back when you sell it. The value of income property can be defined as the present worth of all rights to these future benefits. Like residential property, commercial real estate offers some tax benefits as well.
There are no magic numbers or formulas for estimating the value of income property. It’s a comprehensive process. To acquire a sound real estate investment, you have to go through all the steps. Even if you plan to acquire commercial property for your own business, the same principles apply. This is because commercial real estate value is based on what you could reasonably expect to receive in the form of rent along with the future sale of the property.
History of Sales and Listings
You can learn a great deal from the sales and listing history of a property. Your real estate agent should be able to help you with this. What did the property sell for in the past? If the owner has made considerable improvements, or if the real estate market has improved, the value has probably gone up.
Why is the owner selling? If he or she has not made money on the property, or if it’s in foreclosure, the owner may have paid too much. If the owner has not made significant improvements, or if the real estate market has declined, the value may have gone down.
Has the property been listed for a long time without any serious purchase offers? If so, it could be over-priced. Has the property previously been in escrow one or more times but the prospective buyers failed to qualify for a loan? This is another indication that the property may be over-priced or have defects.
Tenants and Leases
When a property is fully occupied with stable long-term tenants, you know how much income you can expect. For this reason, fully occupied properties usually have a higher value than vacant ones.
Properties with vacancies raise several important questions. Why are there no tenants? Why did the previous tenants leave? Has the property been poorly managed? Were the rents too high? Is the property defective in some way? How long, how much money and how much effort will it take to find and keep new tenants? And how much rent can you expect to receive?
Another, but less common situation is a tenant with a long-term lease. This can be a good thing, unless the tenant is paying less than market rent. If so, the tenant may have a type of property right called a “leasehold interest,” which reduces the owner’s “leased fee” interest. The sum of these two interests equals the total, or “fee simple” value of the property.
Local Market Conditions and Trends
Real estate markets are rarely in balance because supply seldom equals demand. Instead, the market is either oversupplied (a buyer’s market) or undersupplied (a seller’s market). Real estate follows a cycle of boom and bust just like the stock market. Naturally, everyone would like to buy at the bottom of the market and sell at the top.
Experienced investors know it’s almost impossible to predict the top or bottom of any market. It’s much easier to observe current market conditions and trends. An oversupplied market lowers real estate values and an undersupplied market raises them.
Long listing times (days on market prior to sale) and a high ratio of listings to sales indicate an oversupplied market. Short listing times and a low ratio of listings to sales indicate an undersupplied market. Your real estate agent can give you these figures, which are compiled by the local multiple listing service (MLS). Larger metropolitan areas may even publish these figures in the real estate section of the newspaper.
It’s not unusual for different sectors of the same real estate market to have different supply and demand characteristics. Houses priced under $150,000 might be selling like hotcakes while office buildings may not be moving at all.
Real estate value is affected by other trends as well – inflation, unemployment, interest rates, consumer confidence levels and global financial markets.
Special Markets
Some types of income properties belong to special real estate markets which transcend the local economy. For example, campgrounds, motels, golf courses and resorts may be affected by regional, national and even global trends in leisure time and disposable income.
If you are considering buying a campground, for instance, you should work with a real estate agent who specializes in this type of property and can advise you about national trends.
The Neighborhood or District
The neighborhood or district probably has the single most significant influence on property value. The word “neighborhood” usually refers to residential areas, while the word “district” normally describes commercial areas, but the concept is the same.
Like real estate markets, neighborhoods and districts follow distinct cycles of growth, stability, decline and revitalization. Is the district declining, or is it showing signs of improvement? Property values tend to fall when a district is deteriorating and rise when it’s recovering.
Commercial buyers should study the district where the property is located. Is it a central business district, a harbor, a hospital district, a commercial strip or a historic village? Does the district have a lot of pedestrian traffic? Is it easy to find a parking space?
Adjacent and off-site uses can also affect property value. A nearby supermarket generates vehicle traffic, while a tourist attraction or park generates pedestrian traffic.
Boundaries and Easements
Lot lines should be clearly established on paper and marked on the ground. If there is any doubt you should ask to see a survey map and have a licensed surveyor locate the property corners.
Locating the lot lines is important for two reasons. It allows you to calculate the exact lot size, which is essential for estimating land value. Also, it may reveal potential boundary line disputes and building encroachments which can reduce value.
Easements can also influence value. A preliminary title report will identify any recorded easements along with any special conditions attached to them. Easements, like property boundaries, should be clearly established on paper and located on the ground.
Planning and Zoning
The city or county zoning ordinance describes the type of land use allowed on the property. It also specifies the development density, the height and setback of any buildings and any off-street parking requirements. Also, the zoning ordinance will help you find out if the property can be divided or assembled with other lots to increase its value.
If the zoning ordinance does not allow exactly what you want, the city council or county board of supervisors may grant a variance or use permit. If you need special permits, be sure to make your offer contingent on those permits being granted.
Some older buildings may have legally nonconforming uses that were established before the current zoning ordinance took effect. These “grandfathered” uses can add value, especially if they permit higher densities or more profitable activities than current zoning allows.
The city or county general plan is even more important than the zoning ordinance because it establishes the goals and policies for community growth and development. By law, the zoning ordinance must conform to the general plan. Contact the planning or building department to obtain the exact language from both the general plan and the zoning ordinance that applies to the property and the neighborhood or district where it’s located.
Remember, zoning can change. The city or county has the legal right to “down-zone” property without compensating the owner. On the other hand, property owners can reap a windfall if their property is “up-zoned.” The general plan will help you understand community growth and development patterns and anticipate future zoning changes.
Special zoning districts, called “overlay zones” can apply additional restrictions. These include historic districts, planned development overlays and the state-wide California Coastal Zone. While more restrictive zoning complicates the permit process, it tends to enhance property values.
Access and Utilities
The quality of vehicle and pedestrian access may not be that important for office buildings or residential income property. However, it’s crucial for retail stores.
Some retail businesses need good pedestrian traffic. Others must have frontage on a major road with easy access and ample parking. The quantity of people or cars a business is exposed to determines the type of tenant and the amount of rent. The potential rental income, in turn, determines the value of the property.
In urban areas, most people take public utilities for granted. But in rural areas we have become accustomed to water shortages, extended power outages and even building moratoriums based on the lack of water and sewer capacity. The village of Mendocino, for example, has an extremely limited water supply. For this reason, a car wash or laundromat in Mendocino would probably be a bad investment.
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