Properly assessing the value of income- producing commercial real estate depends on a number of factors beyond its physical structure and location on the map. Methodologies employed to arrive at a figure include market comparable sales, which evaluates a property against comparative closed sales and listings; reproduction cost, which weighs the expense to reproduce a given building; and income capitalization, which determines a valuation based on the projected future income stream.
Each of these calculations can help determining an appropriate market value, and a savvy commercial real estate expert will incorporate components of all three. For any type of income producing property (where tenants in place have leases which generate income stream), the income capitalization methodology is the most relevant.
A Tip of the Cap
Deriving valuation from the income capitalization method isn’t rocket science, but it is paramount to understand the different components of income and expense, to be able to determine net operating income (NOI). Improper due diligence or inaccurate financials can result in huge headaches down the road – either in erroneous property values or long-term results that fall short of the projected potential.
NOI is the amount of income a property owner receives aft er expenses but before debt service or income taxes, and it should appear on any profit and loss or income statement. It is derived by totaling up the scheduled gross income – including rent, parking, vending, and other sources – less operating expenses, such as property taxes, utilities, maintenance, and property management costs. Next, deducting losses from vacancy or collections, provides the investor a calculation of effective gross income (EGI).
Determining the capitalization rate – “cap rate,” also known as the income yield – can be a challenge simply because of the number of moving parts. Key factors include the property type, the submarket statistics, the credit of the tenant base (national, regional, local and actual financial condition), the duration of the lease, and whether the rental rates are at, above or below market. Keep in mind, the cap rate relationship to property value is an inverse one: The lower the cap rate, the higher the property price. As a simple example, on a property with an NOI of $150,000, a cap rate of 10 percent translates to a value of $1.5 million. Drop the cap rate to 8 percent, and you’re looking at a property value of $1.875 million.
Unlike checking your stocks on Yahoo Finance, there’s no single source for information on cap rates, which means turning to a commercial real estate expert for the most current information in a given sector. Cap rates constantly ebb and flow in the market, and the class of the commercial real estate at hand and its geographic location are also determining factors. In the current environment, most Class A institutional apartment deals are within the 5-5.5 percent cap rate range. In Phoenix, office buildings might command 7.0-8.5 percent, while markets such as Tucson – or suburban or ex-urban markets in Apache Junction, Maricopa or Green Valley – may have a 100 basis point (one percent increase in cap rate) for similar properties due to the location of these properties, which are considered “tertiary” (third tier) versus the Central Avenue Corridor or Camelback Corridor, which are considered secondary (second tier).
A Word of Caution
An environment with high demand and relatively few distressed properties has kept cap rates lower than they were a few years ago. For investors, that means less risk, albeit with less product and higher property prices.
That said, there are some areas of caution. First, advertised cap rates may be misleading, most commonly when a seller uses pro forma or projected income and expenses rather than actual numbers. The truth is that an unsophisticated owner may not have a full set of financials, but investors should stand firm on requiring actual profit and loss (P&L), income statements, and a balance sheet on every asset.
Second, the submarket, comparable properties, and tenant base/credit should also align with market comparable sales. This is critical when planning for multiple exit strategies, even with a tenant base that looks stable. A net-lease tenant with excellent credit might merit a low cap rate. An investor needs to ensure, however, that market comparable sales and rental rates would lend themselves to securing another tenant – since a vacancy would put them on the hook all of the expenses related to the property.
Finally, different metrics come into play for specific sectors, such as unit cost (apartments), per door (hotels), per square foot (office, retail and industrial), and so on.
Cap rate is the most critical component of evaluating income-producing properties for investors, but a full valuation goes far beyond that: comprehensive data regarding the financial, physical and operational aspects of a property and submarket, as well as in-depth due diligence to confirm that the investment property aligns with the marketplace and prospective owner’s goals. In concert, the valuation tools provide an investor with the ability to acquire wisely and profitably. Beth Jo Zeitzer