Calculate Value
How is Commercial Property Value Determined?
Generally, the value of investment real estate is fairly easy to determine. It is based on several factors; including the
property’s condition and the repairs that are needed; how quickly the seller wants to close; whether the seller needs cash or if a creative
solution can be achieved; and most importantly, the net operating income (NOI), or “cash flow,” that the property
provides. The NOI and a factor called the “Cap Rate”, are combined to calculate a starting point for the amount an investor is willing to pay for
the property.
How Residential Property Value Is Determined
In residential real estate (single family to 4 units), the listing price is established by the seller with a market analysis. Comparables “comps” are
analyzed for a myriad of variables including price per square foot, bedroom count, bathroom count, number of garages, features (pool, central
vacuum, etc), location (cul-de-sac, corner, busy street), views & more.
Adjustments are then made to the subject property to render it equal and pricing is set. For instance if the subject property has one
fewer bedrooms and 500 fewer square feet of living space, its price will be reduced by the value of the extra bedroom and the reduced square
footage.
Once pricing is determined, the property is listed for sale and buyers render offers from that sale price.
How Commercial Property Value Is Determined
In commercial real estate (5 or more units), pricing is established in a completely different manner. Although features (pool, laundry facility, etc) and
location (busy street, etc) are factors, they are considered only to the extent that they enable the property to command higher rent or
decrease its operating expenses in order to increase the property’s current cash flows or Net Operating Income (NOI). Secondarily,
location is considered only to the extent of the potential appreciation of the land. The simplified formula for NOI is:
Income – Expenses = NOI
In commercial real estate, it is these actual cash flows (NOI) and the amount an investor is willing to pay for these cash flows that will
determine the price of the property.
Put simply, if the annual cash flows from a particular property are $100,000 and an investor is only willing to pay $770,000 for those cash
flows, then the property is worth $770,000 to that investor. If another investor is willing to pay $1,000,000 for those cash flows, then
the property is worth $1,000,000 to that investor.
Investors will consider numerous properties in a given area to determine the standard of how much must be paid for particular cash flows in that area. The ”going rate“ in an area can be considered its cap rate. An exact definition and explanation of cap rate is further detailed in the section below this article. But for now, I can best describe the concept of cap rate through example. Here is the formula for determining cap rate:
NOI / Price = Cap Rate
In this example, the first investor required a 13% return on investment or yield and was therefore only willing to pay $770,000 for $100,000 in
annual cash flows.
$100,000 /$770,000 = 13% Cap Rate
The second investor required a 10% yield and was therefore willing to pay $1,000,000 for the same $100,000 of cash flows.
$100,000 / $1,000,000 = 10% Cap Rate
This one year yield (return on investment) could also be described as cap rate. In commercial lingo it would be said that the second
investor requires a “10 cap” and that the first investor required a “13 cap”. This is an oversimplified
explanation to demonstrate the concept.
Commercial investors will determine their risk adjusted requirements for their investments and will base those decisions on opportunity costs.
Opportunity costs are the costs associated with not investing into another vehicle. For instance, if an investor could alternatively
invest their money in a stock, bond, T-bill, CD, or other instrument and yield 12%, why would he/she buy a property which only yields 8%? The
answer is that the shrewd investor wouldn’t.
In order to attract investors, the property owner would have to lower the price to give investors a higher yield or cap rate.
Notice the inverse relationship here. As prices are lowered, the yield to the investor or cap rate to the investor goes up as related to
those cash flows. Conversely, as property prices are increased, the yield to the investor or cap rate on those same cash flows goes
down. Cap rate only takes into account the first year of cash flows and does not account for the second year, third year, etc.
Notice I have not even mentioned appreciation in terms of figuring return on investment. Commercial real estate is primarily considered
based on its cash flows while investing in residential real estate is for anticipated appreciation.
To summarize: In residential real estate there is only one way to profit. The strategy is to carry the property and hope that the market
goes up and that the property appreciates so that the investor can sell for a higher price than was paid. Positive cash flows are
typically non-existent and if present, negligible relative to the anticipated appreciation the residential investment will bring.
In commercial real estate, it’s the other way around. Properties are purchased for their positive cash flows with potential appreciation
as a secondary consideration.
What is the CAP Rate and How is It Used?
Wikipedia defines the Capitalization Rate or “CAP Rate” in part as:
A contraction of the words capitalization rate, the cap rate is the assumed rate of return on an investment in real estate. The cap rate
is commonly used in the valuation of commercial and investment property because it directly links the value to the income produced by the
property.
To determine the cap rate of a property, divide the net operating income by the sales price. From an income standpoint, the higher the
cap rate, the better the investment.
Note that a higher cap rate results in a lower value. Thus, newer properties in upscale areas will tend to show lower cap rates
than their less desirable counterparts.
As an example for establishing a CAP Rate and ultimately determining the Sales Price for a property, let’s use a 10 unit apartment
building. The market rent for each unit is $750.00 per month for a total Gross Income of $90,000.00 per year. An estimated 1 unit
is vacant at any given time. This gives us a Vacancy Rate of 10% (1 unit / 10 units = 0.1 or 10%). Before we can determine the CAP
Rate, we have to resolve the Effective Gross Income (EGI). The EGI is derived by taking the Gross Income and subtracting the Vacancies
and Collections. This gives us an EGI of $81,000.00 ($90,000.00 – $9,000.00).
Our next step is to calculate the Net Operating Income (NOI). The NOI is derived by subtracting the Operating Expenses from the EGI. The Operating Expenses consist of all the costs associated with the operation and maintenance of the apartment building. For example, taxes, insurance, utilities, payroll, administration, maintenance costs, property management fees, reserves for replacement, etc. (Note: unless the actual costs are already higher, maintenance and/or property management fees would each be replaced with an industry standard figure that ranges from 8% to 12% of the gross income or more, depending on the location and condition of the property). Operating Expenses do not include mortgage payments, capital expenditures and depreciation. The EGI is $81,000.00 and our Operating Expenses are $21,000.00. The NOI is derived by subtracting the Operating Expenses from the EGI. This gives us an NOI of $60,000.00 ($81,000.00 – $21,000.00).
The CAP Rate is determined by the commercial real estate market for the specific type of property and geographic area. The CAP Rate
is specifically derived by looking at other similar properties in the local area that have recently sold. By using the formula CAP
Rate = NOI / Sales Price for three to five comparable apartment buildings in close proximity, we can determine the CAP Rate for apartment
buildings in the local area.
NOI | Sales Price | CAP Rate | |
Comparable #1 | $54,000.00 | $491,000.00 | 11% |
Comparable #2 | $157,500.00 | $1,500,000.00 | 10.5% |
Comparable #3 | $201,250.00 | $1,750,000.00 | 11.5% |
Looking at all three CAP Rates, we can choose a rate of 11% to use in our analysis. Based on our NOI of $60,000.00 and a CAP Rate of 11%, the Sales Price for our apartment building is calculated as (NOI / CAP Rate = Sales Price) = $545,454.00
Here is a summary of the math formulas:
- Gross Income – Vacancies and Collections = Effective Gross Income (EGI)
- Effective Gross Income (EGI) – Operating Expenses = Net Operating Income (NOI)
- Net Operating Income (NOI) / CAP Rate = Sales Price
Of course, if you know the Sales Price and the CAP Rate you can find the NOI:
- Sales Price x CAP Rate = Net Operating Income (NOI) or
If you know the NOI and Sales Price, you can acquire the CAP Rate:
- NOI / Sales Price = CAP Rate
The most difficult part of this whole process is developing the CAP Rate. If you do your homework and find the appropriate comparables, you should have no problem with determining the appropriate CAP Rate, and therefore, establishing a starting point for the value, and ultimately a Sales Price for the property.
Flagship Housing LLC is committed to providing you the best sales price and the fastest possible, stress-free sale.
If you (or someone you know) own a property that has reached its time, we invite you to contact us, and give us an opportunity to examine your situation. Let us see if we can help you in the way we have helped other property owners in the past.
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