“Commercial Real Estate Evaluation”
RES 431
Commercial Real Estate Investment
Commercial Real Estate Evaluation
Commercial Real Estate Investing can be tricky; due to the many ways value can be evaluated and determined. This paper will assess the different valuation options for commercial real estate (gross income multiplier, capitalization rate, breakeven ratio, IRR/ NPV). It will also include an assessment of the benefits, as well as examples of each option. I will attempt to apply those different valuations to commercial property for a realistic model.
The acronym DUST is the four characteristics a real estate property must have when determining its value. Demand (Demand is the desire or need for possession or ownership backed by the financial means to satisfy the requirement), utility (Utility is the properties usefulness for the intended purposes), scarcity (Scarcity is an infinite supply) and, transferability (Transferability is relative ease with which ownership rights are transferred from one person to another). (Geshwender, 2010).
Lets first look at GIM (Gross Income Multiplier) valuation method. GIM is standardly used for multi-unit residential properties of five or more and commercial properties. Monetary value is based on the gross annual income of recently sold similar properties. The total annual revenue divided by the final sales price; this results in the GIM. To calculate the GIM, I’ll be using the property from last weeks assignment 3929–3941 S Bristol St, Santa Ana, CA 92704. The annual rent income is $993,996 the GIM for the property would be computed as follows: $10,600,000 /$993,996= 10.66 GIM
One of the benefits of determining the GIM is your income potential is clearly outlined. But there are shortfalls to this method in a word “estimate.” An estimate is not fact; it is a realistic guess that does not account for leases ending soon, or possible pre-negotiated rental increases. Flexibility to change and anticipation, are keys to success.
The income approach is always based on mathematical calculations between value, income, and ROI (rate of return). However, the relationship can be explored in many different ways. One method is determining the capitalization rate. The capitalization rate is not equivalent to the rate of return on investment. This step includes comparing the annual net operating earnings of recently sold similar properties with the sales price of those properties. The rate of performance, percentage, or ratio used to convert income into its value equivalent. A capitalization rate is any rate used to capitalize income. The six necessary steps to in the income approach are:
1. Estimate the annual potential gross income that the property can produce. 2. Deduct for vacancies and rent loss to obtain the effective gross income. 3, Subtract the estimated vacancy and collection loss4. Deduct the annual operating expenses to obtain the annual net operating income(does not include debt service (principal and interest payments) or capital expenditures/capital improvements)5. Estimate the price an investor would pay for the income produced by this particular type and class of property. (1) Compare the annual net operating incomes of recently sold similar properties to the sales price of those properties. (2) The annual net operating income divided by the sales price results in the capitalization (“cap”) rate. 6. Apply the capitalization rate to the subject property’s annual net operating income to obtain an estimated value. |
---|
(Geshwender, 2010)
One of the benefits of the income approach to value is the attention to details. This detailed approach to value is most adapted in the appraisal realm, which speaks volumes about how important this approach is to investors. We always hear the phrase “numbers don’t lie.” This method answers the questions of “expenses.” Are the expenses set expenses or do these expenses change monthly? This question leads to the shortfalls. In the six steps, the work estimate, estimate, estimate is used more than once. An estimate can be incorrect.
Potential gross annual income | $993,996.00 | |
---|---|---|
Plus Recapture | $308,160.00 | |
Income from | $1,302,156.00 | |
Expenses | ||
Total Property Taxes | $140,000.00 | |
CAM & Insurance | $183,181.00 | |
Ground Lease | $66,528.00 | |
Expenses | $347,181.00 | |
Management | $24,000.00 | |
Total | $760,890.00 | |
Capitalization Rate = 10% (overall rate) | $541,266.00 | |
Capitalization of annual net income | $54,126.60 | |
Income value by income approach | $54,126.60 |
The capitalization rate is a figures game. Capitalization rates are attractive to lenders. It provides a detailed report of the shortcomings of cap rate and its many variations, often determined as the ratio between the net operating income produced by an asset and the original capital cost or its current market value.
Another concept to consider when discussing commercial real estate investing is the break-even ratio. The break-even ratio is when a company has neither a profit nor a loss. It’s believed to be at the breakeven point. One dollar more and the company has a profit; one dollar less and the company shows a loss (de Roos, D. (2008). The break-even ratio (BER) is a calculation often made by lenders to decide whether or not to underwrite a loan. BER notwithstanding its quality to lenders, it is often a ratio not generally understood by investors and rarely known how to calculate.
BER is used by banks to calculate the proportion of the incoming and outgoing cash flow created by a rental property. The purpose of knowing what portion of a property’s income can decrease before cash flow acquired from the investment property breaks even with the mortgage payment. The lenders are looking to BER for them to calculate the vulnerability of a property’s income potential (Geshwender, 2010).
he Break-Even Ratio Formula: (Debt Service + Operating Expenses) / Gross Operating Income=BER
An example of BER is assuming a property’s first-year operating costs are $760,890, the annual debt service is $760,890, and the gross operating income is $993,996.
Result
$1,521,780 ($760,890 + $760,890) / $993,996 = 1.53%
When evaluating BER, lenders typically look for a BER of 85% or less. Lenders want the confidence that rents can dwindle no more than 15% for the rental property to still break-even. In the example, expenses are 1.53% of income. In other words, even if the rents decreased as much as 83%, the rental property would still break-even. In this case, this would be satisfactory to a lender willing to accept a BER of 85% or less (Geshwender, 2010).
Net Present Value is the most critical tool in your toolkit for assessing and evaluating commercial real estate. It forms the foundation for other measurements, in particular, the Internal Rate of Return. The Internal Rate of Return, or IRR, is a standard metric in commercial real estate and finance (Geshwender, 2010).
After the CAP rate (Capitalization Rate), it is the most widely used metric to measure the performance of income properties. The Internal Rate of Return (IRR) is how IRR gets calculated or what the “equation” for IRR is. The Internal Rate of Return (IRR) is a discounted rate which yields a zero Net Present Value (NPV) for any given stream of cash flows. There is no equation for IRR. IRR is found through perturbation, or the adjustment of a single element (in this case the discount rate) in the equation for NPV until a satisfactory answer is given (in this case zero). Listed below is an example of how to calculate IRR (de Roos, D. (2008). .
Key Factors:
In the figure below the IRR for the cash flows (200,000); 13,468; 12,591; 11,767; 10,993; and
- Discount Rate = 12.00 %
- Discount Factor = 1/ ( 1+r)^n
- r – is the discount rate n = cash flow
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Future Value | -200,000 | 15,084 | 15,784 | 16,552 | 17,298 | 295,093 |
---|---|---|---|---|---|---|
Present Value | 13, 468 | 12, 591 | 11,767 | 10,993 | 166,309 | |
Net Present Value | -200,00 | 13,468 | 12,591 | 11,767 | 10,993 | 166,309 |
166,309 is 13.87%. Excel can simply hypothesizing a discount rate and then checking to see if it yields a zero NPV. If not, it adjusted the discount rate up or down until zero NPV is found. Once the zero is reached that discount rate as the IRR is presented(de Roos, D. (2008).
Net Present Value = 15,128
IRR= 13.87% (rate of which NPV=0)
The market value is evaluated in some ways and their numerous aspects to consider about change. One concept that is constant to valuation is change. Change is by saying no physical or economic condition remains the same. This means real estate is subject to natural marvels such as tornadoes, fires, and routine wear and tear. All these factors have an impact on the value of the property. Another economic principle that has an impact on property value is anticipation (Wilmore, 2011). The principle of expectation grounded in the belief that “certain” events will occur. An example may be the property value of the home is decreased due to an old commercial building that has not had repairs in a while. The principle of anticipation is the basis of the income approach based on the value which effects GIM, capitalization rates, NVP, and IRR (Wilmore, 2011).
In conclusion, this essay has evaluated the different valuation options for commercial real estate (gross income multiplier, capitalization rate, breakeven ratio, d. IRR/ NPV). This essay has included an example and the benefits of each option. It is safe to conclude value is an ever-changing web. It can be subjective and objective. It can be interpreted and misinterpreted. Analytical research and advice are key to determining a successful commercial real estate future on valuation.
References:
Betts, R. M., & Ely, S. J. (2013). Basic real estate appraisal: Principles & procedures. Mason, OH: Cengage Learning
de Roos, D. (2008). Commercial real estate investing. Hoboken, NJ: John Wiley & Sons
Geshwender, A. (2010). Real Estate Practice and Principle. South-Western, Cengage Learning.
Find you next commercial property. (n.d) Retrieved August 5,2018 from http://www.loopnet.com/Listing/17851855/3929-3941-S-Bristol-Street-Santa-Ana-CA/
Wilmore, D. (2011). Determining the value of commercial real estate. Society of Industrial and Office Realtors, Retrieved from http://www.sior.com/docs/membership
docs/How%20to%20Value%20Comm%20Real%20Estate-%20Willmore.pdf