YOU BUY COMMERCIAL REAL ESTATE FOR APPRECIATION…

YOU BUY COMMERCIAL REAL ESTATE FOR APPRECIATION…

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PART V…

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Before we go into a discussion of getting appreciation from owning commercial real estate we first have to know how we value real estate because appreciation is the increase in the value, the price, of the commercial property that you own.? We’ve talked about how to value commercial property before and now, just to review, it is the Net Operating Income divided by the Capitalization Rate.? The Net Operating Income, the NOI, is the cash flow that you get from taking in rents and paying, or deducting, the ordinary and necessary business expenses of running the property EXCLUSIVE of mortgage expense and depreciation.

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You can pay cash for a piece of commercial property or you can get all sorts of different kinds of financing.? The value of the property has absolutely nothing to do with the way a property is financed.? An apartment building in Los Angeles that has an NOI of $250,000 with a Cap Rate of 5% would be valued at $5 million.? It doesn’t matter if the mortgage on the property is 80% or $4 million or zero.? The value of that building is $5 million.

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I found something on the internet this morning that can explain this in different words:

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Two of the most important metrics in CRE investment are the capitalization rate and the discount rate. The cap rate is applied to one year’s net operating income, while the discount rate is applied to a series of yearly NOI’s or net cash flows. While most seasoned real estate investors use the cap rate for valuation purposes, many do not incorporate the discount rate in their deal analysis.

The capitalization rate is determined by two methods; the net operating income of a property divided by its value or purchase price or by a formula. The formula is the risk-free rate plus a risk premium less a growth rate. The risk-free rate is usually U.S. Treasury securities, typically, the 10 Year T-Note, which is currently about 2.0%. The CRE risk premium is for the 15 risks inherent in CRE that were discussed in last month’s VOM issue. The risk premium has typically been between 3.0% and 10.0% and for this analysis, we will use 7.0%. The growth rate is the growth in a property’s income and with a bustling CRE market, it is estimated at 3.0%. Therefore, the formula cap rate would be calculated today as follows; 2.0% + 7.0% – 3.0% = 6.0%. This is an average cap rate and would need to be adjusted for property type and location.

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This is the first definition of the Cap Rate that I have found that sort of makes sense since I started my journey into commercial real estate.? To the individual who is challenged by numbers let me put this into different words.? First, the paragraph tells you that the capitalization rate is determined by taking the Net Operating Income and dividing it by the price of the property.? That’s just taking my definition of how to value a property and solving for another “X”.? All you did was move the unknown from the value of the building to the cap rate.?

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The rest of the formula makes sense and basically says that if the NOI, the income from the building, keeps rising year after year then the line of increase can be relied upon to keep going up but that the are risk factors, there are ALWAYS risk factors that have to be adjusted for.? So, I am going to give you the very best method of how to value a piece of commercial property.? You put the buyer and the seller in a room with or without their realtors and when they’ve agreed upon a price that is the market value of the property!!!

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Because, when it all comes down to it, the market value of the property is what a willing buyer is willing to pay a willing seller for the property and then you can fill in the blanks of the formula and arrive at a Capitalization Rate.

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I’ve been in these meetings before and the truth is that each side has their own way of computing the price of the property and when each side has moved their number close enough to the other’s number you will probably come to an agreement and a compromise.? There are too many factors that one side may consider that the other side may not that you may start out far apart on the price but, depending on how badly each side wants to make the deal, that’s where the price will end up.

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