As a Commercial
Lending professional, I often begin my conversation with a real estate
investors or commercial buyer when there is a real estate sales contract
already executed.
While most of us
are familiar with the process in purchasing a home and a basic understanding of
market valuations and comparable sales, commercial property is an entirely
different matter.
Commercial
property, other than residential property bought for ‘buy and flips,’ is
valuable primarily because of the income that it produces. For example, apartment buildings generate
rental income, retail stores generate sales and if purchased as an investment,
rental income as well.
So how much is a
commercial building worth? Commercial
buildings in nice areas, facing parks and having a nice view only have more
‘value’ than commercial buildings without these amenities, if they are able to
generate more income for the investor.
The measuring rod
with commercial properties is something called “Cap Rate,” which is short
for “Capitalization Rate”. A cap rate
is quite simply the rate of return expressed in a percentage that a commercial
property generates. Investors, lenders
and shareholders prefer higher cap rate to lower ones. While cap rates vary by
location, property condition and market trends, a wise investor determines a
property's value based on a desired cap rate.
While text book
examples of calculating acceptable cap rates can become very complicated and
always take into consideration vacancy rates, management fees, etc., the simple
formula for a building's cap rate is net operating income divided by sales
price.
An apartment
building, for example, that generates net operating income (prior to loan
coverage) of $98,000 annually that is for sale for $1,100,000 provides a cap
rate of 8.9%
Here’s an easy
way (i.e. fast-n-dirty) to quickly determine a commercial property’s
value. Take the net operating income
(prior to the new loan coverage) and divide it by .10 While 10% may be high in some areas and
low in others it does remind the investor that they need to cover their cost of
capital plus make a decent return (i.e. 3+7; 4+6 etc.). The math is easy as you just move the
decimal over (i.e. $98,000 annual income with a cap rate of .1 = $980,000
market value of the property).
