Most people look at a vacant commercial building and freeze. No tenants, no income, no idea what it's worth. So they either lowball and lose the deal, or they overpay because some broker convinced them to pay tomorrow's value at today's price.
I've been there. And I can tell you, vacancy doesn't mean a building is worthless. It just means you have to be smarter about how you price it.
This came up on our CRE Accelerator mastermind call recently. One of our members, Ryan, was working on a deal where there were only four or five comparable sales in the last year. Not a lot to go on. So I walked the group through exactly how I back into a maximum allowable offer on a vacant commercial property. And I'm going to walk you through it right now.
Here's what we'll cover:
Estimating realistic market rent per square foot
Converting rent into NOI (net operating income)
Applying a cap rate to find stabilized value
Building in your required returns and risk margin
Two methods for calculating your maximum allowable offer
Budgeting for TI, lease-up commissions, and carry costs
Let's get into it.
Start With Market Rent Per Square Foot
When a property is vacant, you don't have a rent roll to work with. So you have to estimate what the building can rent for once it's stabilized.
Here's how I do it. I look at comparable properties in the area. Similar size, similar condition, similar use. I check what's listed for rent on LoopNet and Crexi. And then I call brokers. That second part is key. Asking rents and signed rents are two very different things. Most brokers, if you've built a good relationship with them, will tell you what deals are actually getting done in your market.
I also pull data from every offering memorandum I can get my hands on. Every time a property hits the market for sale in East Nashville, I grab the OM. It shows the rent rolls, the lease terms, the asking cap rate, all of it. I catalog everything because that data compounds over time. The more you have, the more accurately you can underwrite your next deal.
So let's say you've done your homework and you've determined that market rent for your building is $18 per square foot on a triple net basis.
Calculate the Net Operating Income
Now we turn that rent number into an NOI. This is where a lot of newer investors trip up, so let me break it down.
If you're not familiar with how to underwrite your first commercial deal, the basic formula is simple: your effective gross income minus your operating expenses equals your NOI.
Let's use a clean example. Say we've got a 10,000 square foot building at $18 per square foot triple net. That gives us:
$18 x 10,000 SF = $180,000 per year in gross income
Now, even on a single-tenant deal with a 10-year lease, a bank is going to apply a vacancy factor. Typically around 5%. So:
$180,000 x 5% vacancy = $9,000
That drops your effective gross income to $171,000.
From there, you need to account for operating expenses. A good rule of thumb: your operating expense ratio should land somewhere around 35% of gross income. If you're down near 20%, you're probably not maintaining the property well enough, and that'll catch up with you in deferred maintenance. If you're pushing 50%, something's off.
At 35%, your operating expenses come out to roughly $59,850, which gives you an NOI of about $111,150.
Now, the lease structure matters here. On a triple net deal, your tenants are reimbursing you for CAM, taxes, and insurance, so your P&L will show gross rent minus those expenses to arrive at base rent. On a full-service gross lease, you're eating all of those costs yourself, and the math gets more involved. For this example, we'll keep it at our $111,150 NOI.
Apply a Cap Rate to Find Stabilized Value
Here's where you determine what the property could be worth once it's leased up and producing income.
The formula is one you've probably seen before: Value = NOI / Cap Rate.
But the real question is, what cap rate do you use? And this is where all of those offering memorandums I mentioned earlier become gold. You need to understand what properties in your market are trading for. Not nationally. Not some number you pulled off the internet. Your market, your asset class, your condition level.
If you've been tracking deals in your area (and you should be), you might determine that a building like this, with these types of tenants, in this condition, would trade at roughly a 7% cap rate.
So: $111,150 / 0.07 = approximately $1,590,000
That's your stabilized value. That's what the building could be worth after you've done the work. Leased it up, stabilized the income, and gotten everything running.
But that is absolutely not what you should pay for it today.
I've seen this trap more times than I can count. A broker will say, "Hey, once you come in and lease this up, it'll be worth $1.59 million at a 7 cap. So that's the price." I know it sounds ridiculous, because it is, but brokers will try to sell you the future value today. Don't fall for it.
Two Methods to Calculate Your Maximum Allowable Offer
Now that you know the stabilized value, you need to figure out the most you can actually pay and still make the deal work. There are two ways I approach this.
Method 1: The 75-80% Rule
This one is simple. You take the stabilized value and multiply it by 75% (or 80%, depending on your risk tolerance). That builds in a margin for your profit, your risk, and all the costs associated with getting the building to stabilization.
$1,590,000 x 75% = $1,192,500 all-in maximum
That means your purchase price plus closing costs, tenant improvements, lease-up commissions, carry costs, everything, can't exceed $1,192,500.
This method is fast and gives you a solid ceiling. But it can miss some of the finer details.
Method 2: Subtract Your Required Returns
This is how I prefer to do it because it forces you to think through every dollar.
I always aim for a 2x equity multiple over five years. That means if I put $100,000 into a deal, I need $200,000 back in five years, including cash flow, sale proceeds, everything.
Let's say I'm planning to bring $300,000 down on this deal. At a 2x multiple, I need $600,000 back.
So I take the stabilized value and subtract my required profit:
$1,590,000 - $600,000 = $990,000 maximum purchase price
But we're not done. What about capital improvements? Let's say TI and renovations will cost $150,000. Now:
$1,590,000 - $600,000 - $150,000 = $840,000 maximum purchase price
At $840,000, I'm basically doubling the value of the property to make the returns work. That tells me this deal requires real value creation, and I need to be confident I can execute.
Don't Forget the Hidden Costs
Here's where a lot of investors get burned. They budget for the down payment and forget about everything else.
When I'm stress-testing a deal, I make sure I'm accounting for:
Closing costs. Typically 1-2% of the purchase price.
Leasing commissions. On our 10,000 SF example at $18/SF on a 5-year lease, that's a $900,000 total lease value. At 6% commission, you're looking at $54,000 in leasing costs.
Tenant improvements. This varies wildly. For second-generation space in decent shape, you might be able to match your rent rate ($12-16/SF in TI for $12-16/SF in rent). For a dark shell where you're building out bathrooms and HVAC from scratch, you could be looking at $24-32/SF. On 10,000 SF, that's anywhere from $120,000 to $320,000.
Carry costs. If the building sits vacant for six months while you're leasing it up, you're paying the mortgage, the utilities, the insurance. That adds up fast.
Construction contingency. Because you never know what's behind the walls. I recently tore open a wall on a deal and found electrical from the 1940s with no sleeves. Fire hazard. Cost me $180,000 to fix. That's why you always carry contingency in your construction budget.
A Smart Move on Tenant Improvements
Here's something I want you to keep in your back pocket. You can actually structure TI as a win-win by amortizing the cost into the lease.
Say a tenant wants $10/SF in improvements on a 5,000 SF space. That's $50,000. If you amortize that at 8% over the 60-month lease term, it adds roughly $1,000/month to their rent. Over 60 months, you collect about $60,000 on a $50,000 investment. That's a 20% return just on the TI dollars alone.
That's why sometimes it's actually better for you to do the improvements than not. It just depends on how you structure the lease.
Key Takeaways
Vacant doesn't mean valueless. You just have to underwrite future income and back into what you can pay today.
Start with market rent. Use comps, OM data, LoopNet, Crexi, and broker conversations to nail down realistic rent per square foot.
NOI and cap rate give you stabilized value. Value = NOI / Cap Rate. Track offering memorandums in your market so you know what realistic cap rates look like for different asset types.
Build in real margins. I target a 2x equity multiple over 5 years. Your MAO needs to leave room for both value creation and investor returns.
Use both MAO methods. The 75-80% rule is quick and clean. The subtract-your-returns method is more precise. I'd recommend running both and seeing where they land.
Budget beyond the down payment. Closing costs, TI, leasing commissions, construction, carry costs. These can push your all-in basis way higher than you planned.
Never pay tomorrow's value today. If a broker is pricing a vacant building at stabilized value, walk away.
This article is adapted from Office Hours on the Tyler Cauble YouTube channel.
Want to learn how to underwrite deals like this with confidence? Check out the CRE Accelerator, my step-by-step program for building your commercial real estate portfolio. We cover underwriting, deal analysis, and everything else you need to start investing in commercial real estate.