Commercial Property Value - How to Determine What It's Worth
In residential real estate, the listing price is determined by the seller. 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 with those comps. For instance if the subject property has one fewer bedrooms and 500 fewer square feet of living space, it's price will be reduced by the value of the extra bedroom and the reduced square footage.
In commercial real estate, pricing is determined by the income the property produces. Although physical 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 cash flows or Net Operating Income (NOI). Secondarily location is considered to the extent of the potential appreciation of the land. In commercial real estate, it is these cash flows 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 willing to pay $2,000,000 for those cash flows, then the property is worth $2,000,000 to that investor. If another investor is only 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 is typically paid for particular cash flows in that area. The "going rate" in area can be considered its cap rate. An exact definition and explanation of cap rate will be detailed in a subsequent article. This article will address the concept of cap rate.
In this example, the first investor only required a 5% return on investment or yield and therefore could pay as much as $2,000,000 for $100,000 in annual cash flows to obtain his/her 5% desired return. The second investor required a 10% yield and was therefore only willing to pay $1,000,000 for the same $100,000 of cash flows. Different investors require different yields which affect the price ultimately paid for the property.
This one year yield 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 only required a "5 cap." This is an oversimplified explanation to demonstrate the concept. The "one year yield" distinction is made as cap rate only accounts for one year yield, usually the following year from when the investor purchases the property. To determine the combined yields of multiple year returns, different measures are used and will be detailed in a subsequent article.
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 something else. For instance, if an investor could alternatively invest in a stock, bond, T-bill CD, or other instrument and yield 15%, why would he/she buy a property which only yields 5%? In order to attract investors the property owner would have to lower the price (increase the cap rate) to give investors a higher yield.
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 the 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. The value of commercial real estate is primarily considered based on its cash flows while investing in residential real estate is for anticipated appreciation.
In residential, there is only one way to make money. The market must go up so the investor can sell for more than the original purchase price. In commercial real estate investors are purchasing cash flows. In our example, if the second investor paid all cash, at a 10,cap which values the property at $1,000,000, that investor would be paid back 100% of the initial investment after 10 years and as of the 11th year, the investor would have $100,000 of annual cash flow from that single property. Because there is no mortgage called debt service in commercial real estate, this would be the cash flow before tax to the investor. In other words, other than income tax, this is the spendable cash to the investor on an annual basis.
Hopefully the property will have appreciated as well and the market will be favorable. But in the very worst case if no appreciation occurred whatsoever, the investor would still enjoy the $100,000 of annual cash flows. The beauty of commercial real estate is in the ability to plan. If you buy a residential property, you must sit and wait for the market to appreciate. The problem is that you never know when this appreciation will occur or how much. You can't plan. And, you're at the mercy of the market. In commercial real estate, as long as rents don't decrease substantially and vacancies don't increase, you know ahead of time how much money you will make regardless of market appreciation.
Now consider this. Let's say that the second investor decided not to pay cash and instead leveraged the property with a 10% down payment or $100,000 to purchase the $1,000,000 property. Let's also consider that the remaining $900,000 was financed at 7% for 25 years which is the typical term length in commercial financing. With a fully amortizing loan the annual payments would be $63,000. In commercial real estate, paying debt owed to the lender is called debt service. In residential, it's called paying the mortgage. From the $100,000 cash flows (NOI) from the property the debt is paid leaving $37,000 of cash flows before tax. For simplicity sake, I will not account for tax effects on income or yields.
In this example, in Year 1, the investor has earned $37,000 for a $100,000 cash outlay or a 37% cash on cash return and will do so for 25 years until the debt is paid off assuming no changes to the income. Subsequently, the investor will enjoy the entire $100,000 of annual cash flows as there will be no debt service. To calculate the combined cash flows from multiple years the investor would look at a measurement called Internal Rate of Return (IRR). For the scope of this article I will not address IRR. But remember, Cap Rate is for a single year's return and cannot account for multiple years with different cash flows each year.
Notice again, I haven't even spoken about appreciation which may or may not occur. But even if no appreciation occurs to our example property, this is still an incredible investment! Now obviously during a 25 year period these cash flows will change as rents will likely be increased and capital improvements will likely be needed (new roof, etc). But again, I'm keeping it simple for example purposes.
To summarize: In residential real estate there is only one way to make money. 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 properties are purchased for their positive cash flows AND potential appreciation. It is because of these cash flows that commercial real estate is less risky.
It is for this reason that commercial real estate is more stable and can weather the market storms that residential investments cannot and it is for this reason that the super wealthy own residential to live or vacation but invest in commercial real estate to create their massive wealth.
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Karen Hanover is well known as a Certified Commercial Real Estate Advisor, President of the National Apartment Investors Association, Chairman of the National Commercial Real Estate Advisory Board and Senior Instructor for both the Self Storage Education Institute and the Apartments Education Institute.
As a CCIM Candidate, a highly prestigious designation, often called the "Ph.D. of commercial real estate" Karen works as a busy commercial real estate agent with Marcus & Millichap one of the nation's largest and most highly regarded commercial brokerage firms.
Sought by industry insiders for their toughest deals, Karen has helped thousands to create wealth in commercial real estate with less risk even in today's uncertain economy.
Karen founded the Commercial Investment Education Institute which provides educational instruction for investors on multiple subjects including apartments, self storage, office buildings, retail centers, mobile home parks and more. Her courses are taught in a friendly and easy to understand manner.
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