Commercial real estate is a numbers game. As a buyer, it’s important to know how to value a commercial property’s investment worth. Many complexities come into play and some formulas do not account for the little details. Take the time to calculate every aspect you can cover if you want to spot no-brainer deals.
Two of the most popular measurements of investment value for commercial real estate are the “Cap Rate” and “Net Rental Yield”. We will break these down in great detail and then give other examples of value formulas to use.
Cap Rate of a Commercial Property
A commercial property’s “cap rate” is the “capitalization rate”. This figure is calculated by determining the ratio of NOI to property asset value.
NOI stands for Net Operating Income.
The “asset value” is essentially the sale price.
How to Calculate Net Operating Income (NOI)
You are calculating the amount of operating income after all expenses. You do this to figure out how much cash flow the property will generate.
You must factor both operating costs and vacancy losses.
Some examples of operating expenses include property taxes, rental property insurance, maintenance and repairs, property management fees, and miscellaneous spending. You can look at what the current owner is paying for these expenses. You can also look at market averages. For example, 1% of property value is the typical amount that an investor will spend on maintenance expenses.
Some examples of income include rent or lease payments, billboard fees, and vending machines or laundry service profits. Value these extra income sources at net value before factoring them into the NOI calculation.
As for vacancy losses, you can look at the actual figures or factor the standard rate in the property’s market. Some buildings have unique circumstances. In certain cases, fixing a few things could reduce your vacancy rate significantly. If the vacancy is already low, go with the current statistic for the building when calculating vacancy loss. Multiply the number of months any units are vacant by the rent value of them to determine the total loss. Add this to the expense side and subtract it from the income.
The NOI valuation formula does not factor in principal loan payments, interest premiums, depreciation, amortization, or capital expenditures. These factors will vary depending on the borrower. The point of the NOI formula is to value the property itself.
When to use the NOI calculation method…
As an investor, the NOI should be calculated prior to make an offer on a property. This formula can also be used after obtaining ownership. NOI stats help to determine cash flow and the value of the income and expenses can always change. By measuring all income and expenses, it will be easier to see where you can cut costs and profit more.
Tip: The NOI will vary heavily between properties. You must consider the other costs, such as low rent and high expenses, to determine whether the investment is workable. You might find that the NOI creates a nice cash flow but the mortgage costs eliminate most of the profit. In this instance, any drop in the vacancy or sudden high expense could prove to be too costly.
So, What’s the Cap Rate?
You now have all the information you need to calculate the NOI. The next step is to figure out the ratio of NOI to property asset value. Let’s say a commercial property is available for a $500,000 purchase price and it has an NOI of $50,000. In this scenario, the cap rate is $50,000/$500,000 which makes for a 10% cap rate.
What is a Good Cap Rate?
A good cap rate in one city might be a terrible rate in another. It is important to look at the market statistics for your area. Search for sales comps for similar commercial properties and see their cap rate. This will give you an idea of what you can expect and what it takes to be outperforming the local market.
However, generally speaking, 4% is a solid cap rate. Anything north of that figure will be a strong number to see. Any south of it needs further evaluation. A lower cap rate might exist as a result of a high level of vacancy. If that is the case, you need to determine what is causing the high vacancy. Compare the vacancy rate for similar properties in the area—if it is much higher, there could be more room to push the cap rate higher.
If you are a buy and hold investor, remember that your cap rate can go up. If it’s a growing market, the demand will increase and rents will go higher. The more income the property generates the greater the cap rate will be. You can look at predictive growth to determine what the cap rate might be in the next few years.
Calculating the Net Rental Yield
The Net Rental Yield is a figure that factors property expenses but not debt service costs. This formula is similar to the calculation for Net Operating Income. However, the one key difference is that your income tax costs are brought into the equation.
The Net Rental Yield is a good means of valuing commercial property. This statistic can be used to help investors avoid properties that have marginal profit potential. If the market goes down a little, a negative ROI might occur. This situation is very risky because it means a negative cash flow which pressures you to sell the property at a loss. Failing to sell early could lead to further recurring losses until you later sell at a bigger disparity.
Basically, you want to look at the Net Rental Yield as the true income value. You can then subtract your debt service costs from this figure to determine the actual cash flow. This figure is your investment return rate. From there, you will know precisely whether it is worth putting your money into the building or not.
To put it simply, take your NOI and subtract your tax-related expenses. You now have your Net Rental Yield. All that is not brought into the equation is your debt principal and interest payments.
Other Calculations for Commercial Property Value
Some other calculation methods that are used by commercial real estate investors include the Gross Rent Multiplier, Cash Flow, Gross Potential Income, and Breakeven Ratio.
These methods are not as effective as the Cap Rate or Net Rental Yield. However, each of these formulas are valuable at times. You can collect more data on the investment value of a property by calculating through each of these methods. You might find a weakness that doesn’t show otherwise. It’s better to be safe than sorry!
Gross Rent Multiplier
The Gross Rent Multiplier (GRM) is the ratio between a property purchase price and the yearly income it generates. The GRM does not take into account any expenses at all. This statistic is used to figure out how many years it would take to pay off the purchase price based on the gross rent figures.
The GRM calculation is usually used by investors as a preliminary screening measure. You can determine whether the rental income generated by the building is too low. If you know it is relatively high, then you can break down the statistics further by looking at the expenses.
As an example… A property that costs $500,000 might generate $25,000 in rent each year. At this rate, it would take 20 years to pay off the $500,000. Of course, this statistic does not take into account any appreciation in rental rates either. It is not a super-advanced measurement of value but it does serve as a good screening method.
A quality GRM would be in the 4 to the 7-year range for rough markets. If it is in an in-demand, booming market, it’s okay for it to take longer to pay the property off. Receiving at least 1% of the purchase price in rental income every month would be ideal.
Cash Flow
Calculate the gross rental income for the year. Calculate the amount you pay for the mortgage with interest each year. Factor in how much the previous owner was paying for expenses annually. Include the vacancy loss amount on top of those expenses. Subtract all outputs from inputs to determine the property’s cash flow.
The cash flow decides how much money you will pocket on your investment. Some factors will play a heavy impact on the cash flow rate of a property. For example, a higher downpayment could give you a lower interest rate and mortgage payment. Your monthly cost will go down as a result which means you will pocket more profits every month.
You do not want to overextend yourself to increase your cash flow. Any money that you tie up could have been used elsewhere. A lost opportunity can be costly. You should use the “Cash on Cash” calculation method as well. Divide your invested capital by annual cash flow to determine your Cash on Cash return.
In some cases, you might want to look for lucrative opportunities to reduce invested capital. For instance, the seller might cover the downpayment for you to seal the deal. Your invested capital would be much lower which could offset a higher mortgage payment. If you purely care about the property’s income potential, these opportunities are very appealing. You can build a nice portfolio of properties through tricky methods but it takes extensive research and planning to pull off.
Gross Potential Income
The Gross Potential Income takes into account what you might be able to generate for income from a property. You are not looking at the current figures so much as to what you could manage if you optimize your investment. For example, a property might need some repairs or renovations to increase the number of rented units. By investing in this capital you could increase the property’s income potential.
At bare level, the GPI is calculated by looking at a property with 100% occupancy. You must effectively value the rent rate for any vacant units. In most cases, this will be a simple measurement. A building might have a vacancy of a few months between tenants and always rent for the same amount. But, it gets more complicated if any units have been vacant for a long time—because there’s likely a (costly) reason for that.
The GPI is a good figure to use when shopping the market for commercial real estate investment opportunities. You might find some properties that seem like a bad deal but their high potential income makes them appealing. You need to be careful when getting into one of these investments. Some will be major duds and cash burners, while others could prove to be the best real estate purchase of your lifetime.
Breakeven Ratio
The Breakeven Ratio is a pretty effective measurement of investment value. It takes into account all of your operating expenses and also your debt service cost. This total is divided by the potential rental income. You can use this figure to identify how much the market can swing down before you start operating at a loss.
A good ratio will vary depending on many factors. However, the ratio should be below 85% in most cases. This means you have a 15% safety margin where you can allow rent rates to drop by 15% and still be safe. Make sure you calculate this before investing in a rental property because it could save you from a catastrophic loss. The Breakeven Ratio is especially important in a bubbling real estate market where a downturn in prices is more likely.
Conclusion
Investing in commercial real estate can be tough at times. However, it is very much a numbers game. You can find profitable deals if you take the time to compare what’s on the market and crunch the data. The key is to be extra cautious before making an offer and making sure it is a good deal in every way possible.
So, consider your Cash on Cash return. Make sure you have a nice net cash flow. Take a shot on properties that have room for growth. Avoid the marginal investment opportunities. Also, do not feel like you need to find a deal today… A property might look nice but, if the numbers don’t add up, it’s not worth the risk.