What is it that really creates value in commercial real estate? Well, in residential real estate, such as single-family homes, what creates value is location. Location, location, location is the saying that you always hear. The most expensive homes are in the best of neighborhoods, right? But location isn't the only factor that creates value in commercial real estate. In fact, there are two factors that are actually more important than location: use and the lease. We cover these in the following sections.
Use: How the property is used gives value
How a property is used is probably the most important factor in understanding values in commercial real estate. Here's why: Let's say that you have a 5-acre lot directly across the street from a brand-new luxury apartment complex that has a three-month waiting list for new tenants. Common sense says that you should develop it into another apartment complex because there's great demand. It appears big money awaits you.
But upon further research, you find out that the city says that your 5-acre lot can only be used for agricultural purposes. Where is there greater investment value — in a high-rent luxury apartment complex or a tomato farm? Exactly — the luxury apartment complex! Therefore, how a property can be used determines its value.
How a piece of land or property can be used is, for the most part, controlled by the city's local planning department. The planning department keeps control of this through zoning. Zoning specifies which type of property may be built in specific areas. Zoning is a governmental system in regulating land use and is typically master planned by the city. In the preceding example, the city has zoned that particular piece of land, the 5 acres, as agricultural use. This means that it can only be used for agricultural purposes and can't be used to build apartments, retail centers, office buildings, or industrial parks. The 5 acres would achieve its highest investment value if it were zoned for apartments or even retail — but the planning department may have other development plans for the area.
Here's a quick example showing how use can have a significant impact on property value: Let's say you go ahead and decide to farm and grow tomatoes on your 5 acres. You can produce a thousand 25-pound cartons of tomatoes per 5 acres. You can sell them for $2 per pound, which produces an income of $50,000. After you deduct a production cost of 30 percent, you're left with $35,000 of income over 5 acres. So, you end up with $7,000 per acre. If you were to capitalize that at 8 percent, here's what it would look like: $7,000 * 8 percent = $87,500 per acre. And here's how to get the estimated value over the 5 acres: 5 acres x $87,500 = $437,500.
Now, let's say that the 5 acres was approved for use as an apartment building. On your 5-acre lot, you can fit 2 acres of living space. Each acre is 43,560 square feet. So, 2 acres equals 87,120 total square feet of living space. It's reasonable to say that apartment sales are going for $50 per square foot. Therefore, 87,120 square feet x $50 per square foot = $4,356,000, which is the estimated value for the apartment building.
Wow, how exciting! This is what commercial real estate is all about — finding opportunity, creating a product that betters humankind, and then reaping the rewards. The challenge in front of you in this example is to get the zoning changed on the 5 acres to allow an apartment building. To find out more on zoning and land development, flip to Chapter 15.
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