A minor epiphany about valuations for larger buildings

Just had a minor epiphany while walking over to the office from breakfast that I thought I’d share with you.

It’s kind of embarrassing, in a “slap-myself-in-the-head-for-not-recognizing-this-earlier” kind of way, but I’m all about honesty on this blog, so here goes…

Regular readers know I spend a lot of time thinking about the components of value. What I mean by this is, basically, what are we actually buying when we buy a building?

I was stewing over just this question when an MLS alert showed up on my phone for a large building in Hollywood. As I usually do, I did a quick calculation of the asking price per square foot to see if there was any chance I’d be interested.

The number came back at around $400 / sq ft, which is an absolutely ludicrous price for a rent control building unless the rents are high and the cap rate is good (fat chance, in this market). This in keeping with my general observation that larger buildings in LA tend to trade at higher prices.

I’ve always explained the higher prices for larger buildings by telling myself that institutional and quasi-institutional capital is willing to accept lower yields, and therefore pay higher prices.

But another explanation just hit me: Large buildings are often on larger plots of land. And price per square foot, my favorite valuation metric, ignores land value (the “square feet” in question are square feet of structure, not land).

So, here’s my new understanding: For large buildings on large plots of land, particularly where the building is not developed to maximum current density, I need to dig deeper to determine if the land component is sufficiently valuable to justify a higher price per square foot.