If done correctly, acquiring commercial real estate can help provide you with long-term stability and cash flow. However, if the fundamentals of valuation and acquisition are ignored you get chaos. Here are four ways to think about valuing a commercial property. Think through all four methods before making an acquisition offer. If the property fails any of the four tests, pass on it. The tests are:

1. Direct cap value

2. Discounted Cash Flow (DCF)

3. Cost per square foot

4. Replacement cost

Direct cap value is a “back of the envelope” type of calculation. To get this value first you compute the amount of Net Operation Income (NOI) the property will produce in the first year you own it. If the property has NNN leases this is fairly easy to do. Otherwise you have to make sure to add up all gross revenues and subtract expected expenses. The value of the building equals the NOI divided by the cap rate. Cap rates vary across markets. In theory, a cap rate equals the interest rate minus expected growth rate plus a risk premium. Since no one knows what a good risk premium is for real estate, coming up with a cap rate is a difficult task. The best rate to use is to use the implied cap rate for the most recent transaction to close in your market. Make sure this transaction is comparable in size, scope, and property type. This will give you a rough value. For instance, if you have $200,000 of NOI in the first year, and the cap rate is 8%, then your value is roughly $2.5 MM.

Discounted cash flow (DCF) is a method used by real estate professionals to value a building. This method requires you to project out the cash flows on the building over an extended period (5 or 10 years is common) and then discount them back at your opportunity cost of capital. DCF is complicated because you will have to estimate costs and revenues beyond the current leases on your property. In addition, this method is difficult because you have to assume a terminal value for the project. This means you have to assume a sale value for the project at the end of the 5 or 10 year period.

Discounting all of these cash flows back at your opportunity cost of capital will give you the Net Present Value (NPV) of the project. If it’s greater than zero, you have a good deal. Determining the opportunity cost of capital for your firm is an exercise that requires full explanation in another article. For many firms they simply impute a hurdle rate. For instance, you may decide that any project requires a 10% return to be approved. In that case you would discount your cash flows back at 10% and see if you are left with a positive value.

Direct cap value and Discounted Cash Flow are valuation methods that are sensitive to revenue projections. To make sure your revenue projections make sense, you want to calculate the asking cost for the property on a cost per square foot basis as well. To do this, simply take the asking price for the property and divide it by the number of rentable square feet in the building (not square feet of property). After doing this, compare that number to other recent property sales to make sure you are consistent with the market place.

The final method is replacement cost. This is different than cost per square foot because this takes into account the cost to actually replace the asset. This is more than just construction cost, but takes into account location. An office in mid-town Manhattan is extremely difficult to replace because of the location. An office in suburban Des Moines is probably a lot easier to replace. Take this qualitative factor into account and make sure you are not paying more than replacement cost for the asset.