I was looking through one of my Valuation Reports the other day, and found a nice quote which demonstrates how valuers evaluate commercial real estate.
“Well located suburban properties, securely leased to national tenants, with modern building improvements, represent prime property investments and sell on yields of between 6.5% and 8.0%…
Properties that do not possess all of these attributes but have reasonable lease covenants of say 5 years, are selling on returns of 8.5% to 9.5%, depending upon location and building quality.”
Now, your mileage will vary – the numbers themselves will change from region to region. But the key is this: a better quality tenant will give you a more valuable property.
You see, it’s all about risk.
With a big, national company, your tenant has a strong financial backing, which means you can have a lot of confidence in your income.
With a smaller tenant, no matter how well-intentioned or business-smart they are, there is inherently more risk. One big lawsuit, one marital split, one fraudulent employee, or some unexpected occurrence, and their business (consequently, your income) is under threat.
People are willing to pay more for a lower risk.
Back to my valuation report. The valuer went on to value my property using a capitalization rate of 8.75%. This reflected the fact that my property had a single, independent operator.
Now, I’ve got a chance to re-lease the building, and I’m going after a national tenant.
Let’s say my property brings in $50,000 per year in rent. Assuming the valuer chooses the mid-point of the respective ranges, here’s the math:
With a lower-quality tenant, my property gets valued with a capitalization rate of 9%, giving it a value of $556,000.
With a national tenant, my property gets valued with a capitalization rate of 7.25%, giving it a value of $690,000.
So, switching from a standard, independent tenant, to a strong national tenant will make me $134,000. Even if the rent doesn’t change at all. That’s a massive difference! Makes it worth acquiring a good tenant, doesn’t it?
Some people are surprised by this. It’s the same land. It’s the same building. Surely the value can’t just change like that? What you have to remember is that a potential buyer doesn’t just buy the land and building. They also acquire the tenant and the lease. That’s why the value can change so significantly overnight.
Tenant Quality Affects Property Value!