A friend of mine from college called me late last week with an interesting problem: He wanted to know how to value a vacant building he was considering buying.
There are two good ways to think about this problem:
The first might be thought of as “price per pound“, where we are looking at the physical land and structure, rather than at the income that land and structure generate. For this kind of analysis, we calculate a reasonable price per square foot for both the land and the structure based on recent, comparable transactions. We also keep in mind the cost of buying a comparable piece of land and building a comparable structure… you rarely want to pay more to buy something than it would cost to build.
The second, more problematic, manner of valuing a vacant building is to use an “estimated income” approach. With occupied buildings, it’s easy to evaluate a property based on it’s income; you just calculate the net operating income (“NOI”) the building is generating, divide it by the price you’re being asked to pay, and compare the quotient, called the CAP rate, to other, comparable deals to see if it’s fair. Obviously, the problem with the vacant building is that there is no NOI.
But you can estimate an NOI. First, you need to estimate the income the building can generate. It’s important you make this guess based on the present condition of the building. (If you estimate income assuming a renovation, then you will end up paying the seller a price for his un-renovated building which reflects the renovations you are going to pay to do!) So, look at the present condition of the building and compare it to other recently rented buildings and those on the market and figure out what kind of rent the building can generate.
Next, you need to estimate the expenses for the building. There are two key mistakes to avoid here: (1) Don’t blindly take the seller’s current expenses… vacant buildings use less heat, power, water, etc. than occupied ones!, and (2) Don’t assume any renovations to reduce costs (more efficient fixtures, heater, etc.)… otherwise, you’ll end up paying the seller for work you’re going to pay to do.
Once you have reasonable estimates for rent and expenses, you can subtract the latter from the former to get the estimated NOI. Then, you divide the NOI by the asking price to determine the estimated CAP rate, which you can compare to other, similar properties recently transacted or on the market.
Think this stuff is too boring / difficult to consider? Vacant buildings are very often where the opportunity is, because sellers and brokers screw up their estimates of income and/or expenses and therefore mis-price their assets. My current house and the Silver Lake fourplex I recently helped my parents buy were both vacant when we acquired them.