Commercial real estate properties, especially professionally managed ones, can be costly investments. That’s why it’s critical to understand and accurately calculate the opportunity cost of your deal.
There are expenses associated with the property itself and then there are operational costs that vary depending on the building and the tenant. And just like any investment, there are certain costs associated with holding onto it for a period of time.
The opportunity cost is the loss in profit that occurs when an asset’s potential earnings under another use or in another location cannot be realized due to its current use.
Oftentimes, commercial properties require tenants to sign long-term leases; this creates a situation where there may be limited options available to change up space in order to maximize revenue and profit potential. These tangible and intangible factors make calculating opportunity costs important when considering making changes such as leasing vacant space, adding new tenants, or selling the property outright.
Why Opportunity Cost Is Important
When analyzing return on investment for a potential purchase, many investors and property owners will do their own internal rate of return (IRR) analysis. The IRR is the discount rate that makes the net present value of all cash flows from an investment equal to zero.
The formula for calculating net present value:
net present value = [present value of future cash flows] – [initial investment]
As you can see, one needs to find out how much they are going to make from the initial investment in order to figure out if it’s a good idea or not.
In real estate, you don’t really know what your initial investment is until after you have owned the building for a period of time and done any renovations or maintenance necessary.
The opportunity costs help you determine what the initial investment could be if you did something different with your property, like sell it or lease vacant space. It’s essentially an apples-to-oranges comparison that allows investors to understand the value of their real estate investments in highly flexible terms.
Calculating Opportunity Cost for Commercial Real Estate
When it comes to commercial real estate, the first step to figuring out opportunity costs is looking at current income minus expenses. From there, you can determine what your opportunity costs are; essentially, this would be the amount of money that property could fetch if it were sold or leased under different circumstances (under contract, vacant space).
When you are determining what you could get for your property, there are a few different ways to go about it.
First, you need to decide if your goal is to sell or lease the property.
If you want to sell the building, the estimated resale value would be fair market value minus any costs associated with selling such as agent commissions and closing costs. This number should theoretically reflect the price at which an informed buyer and seller agree upon; however, in reality, there can be discrepancies given that buyers and sellers don’t always have equal information (the seller generally has more information than the buyer).
If this difference occurs between two parties without either party knowing of the other situation/knowledge—which happens often—then this gap in information is referred to as a “market inefficiency”.
If you are looking to lease your property, then the estimated market rental value would be the current income less vacancy and credit loss. Market rental value is the amount of money that you could reasonably get for renting out your space if it were fully leased on the open market.
A final note about opportunity costs: they will vary depending on what type of business or industry you are talking about. One block might have more demand for one tenant over another; therefore, opportunity costs need to be calculated by area/location—not just across different types of tenants. This can change how much capital an investor has tied up in their property because what one part of town might be worth may be very different than another.
Get In Touch With Caldwell Commercial
Caldwell Commercial can help you determine opportunity costs for your commercial real estate investments by using its extensive database of recent sales information and data on leases throughout South Carolina.
Additionally, our team is happy to provide advice about how to improve the profitability of your buildings through better asset management techniques such as lease restructuring or finding new tenants. If you would like help determining opportunity costs or learning more about our property management services, contact our office today.
Contact us at: (843) 566-1888 or email@example.com for an opportunity cost analysis along with a list of potential ways to increase the profitability of your property.