In residential real estate, the listing price is determined by the seller.
Comparables "comps" are analyzed for a myriad of variables
including price per square foot, bedroom count, bathroom count,
number of garages features (pool, central vacuum, etc), location
(cul-de-sac, corner, busy street), views & more.
Adjustments are then made to the subject property to render it equal
with those comps. For instance if the subject property has one fewer
bedrooms and 500 fewer square feet of living space, it's price will be
reduced by the value of the extra bedroom and the reduced square
footage.
In commercial real estate, pricing is determined by the income the
property produces. Although physical features (pool, laundry facility,
etc) and location (busy street, etc) are factors, they are considered
only to the extent that they enable the property to command higher
rent or decrease its operating expenses in order to increase the
property's cash flows or Net Operating Income (NOI). Secondarily
location is considered to the extent of the potential appreciation of
the land. In commercial real estate, it is these cash flows and the
amount an investor is willing to pay for these cash flows that will
determine the price of the property.
Put simply, if the annual cash flows from a particular property are
$100,000 and an investor is willing to pay $2,000,000 for those cash
flows, then the property is worth $2,000,000 to that investor. If
another investor is only willing to pay $1,000,000 for those cash
flows, then the property is worth $1,000,000 to that investor.
Investors will consider numerous properties in a given area to
determine the standard of how much is typically paid for particular
cash flows in that area. The "going rate" in area can be considered
its cap rate. An exact definition and explanation of cap rate will be
detailed in a subsequent article. This article will address the concept
of cap rate.
In this example, the first investor only required a 5% return on
investment or yield and therefore could pay as much as $2,000,000
for $100,000 in annual cash flows to obtain his/her 5% desired
return. The second investor required a 10% yield and was therefore
only willing to pay $1,000,000 for the same $100,000 of cash flows.
Different investors require different yields which affect the price
ultimately paid for the property.
This one year yield could also be described as cap rate. In
commercial lingo it would be said that the second investor requires a
"10 cap" and that the first investor only required a "5 cap." This is an
oversimplified explanation to demonstrate the concept. The "one
year yield" distinction is made as cap rate only accounts for one year
yield, usually the following year from when the investor purchases
the property. To determine the combined yields of multiple year
returns, different measures are used and will be detailed in a
subsequent article.
Commercial investors will determine their risk adjusted requirements
for their investments and will base those decisions on opportunity
costs. Opportunity costs are the costs associated with not investing
into something else. For instance, if an investor could alternatively
invest in a stock, bond, T-bill CD, or other instrument and yield 15%,
why would he/she buy a property which only yields 5%? In order to
attract investors the property owner would have to lower the price
(increase the cap rate) to give investors a higher yield.
Notice the inverse relationship here. As prices are lowered, the yield
to the investor or cap rate to the investor goes up as related to the
cash flows. Conversely, as property prices are increased, the yield
to the investor or cap rate on those same cash flows goes down.
Cap rate only takes into account the first year of cash flows and
does not account for the second year, third year, etc.
Notice I have not even mentioned appreciation. The value of
commercial real estate is primarily considered based on its cash
flows while investing in residential real estate is for anticipated
appreciation.
In residential, there is only one way to make money. The market
must go up so the investor can sell for more than the original
purchase price. In commercial real estate investors are purchasing
cash flows. In our example, if the second investor paid all cash, at a
10,cap which values the property at $1,000,000, that investor would
be paid back 100% of the initial investment after 10 years and as of
the 11th year, the investor would have $100,000 of annual cash flow
from that single property. Because there is no mortgage called debt
service in commerical real estate, this would be the cash flow before
tax to the investor. In other words, other than income tax, this is the
spendable cash to the investor on an annual basis.
Hopefully the property will have appreciated as well and the market
will be favorable. But in the very worst case if no appreciation
occurred whatsoever, the investor would still enjoy the $100,000 of
annual cash flows. The beauty of commercial real estate is in the
ability to plan. If you buy a residential property, you must sit and wait
for the market to appreciate. The problem is that you never know
when this appreciation will occur or how much. You can't plan. And,
you're at the mercy of the market. In commercial real estate, as long
as rents don't decrease substantially and vacancies don't increase,
you know ahead of time how much money you will make regardless
of market appreciation.
Now consider this. Let's say that the second investor decided not to
pay cash and instead leveraged the property with a 10% down
payment or $100,000 to purchase the $1,000,000 property. Let's
also consider that the remaining $900,000 was financed at 7% for 25
years which is the typical term length in commercial financing. With a
fully amortizing loan the annual payments would be $63,000. In
commercial real estate, paying debt owed to the lender is called debt
service. In residential, it's called paying the mortgage. From the
$100,000 cash flows (NOI) from the property the debt is paid leaving
$37,000 of cash flows before tax. For simplicity sake, I will not
account for tax effects on income or yields.
In this example, in Year 1, the investor has earned $37,000 for a
$100,000 cash outlay or a 37% cash on cash return and will do so
for 25 years until the debt is paid off assuming no changes to the
income. Subsequently, the investor will enjoy the entire $100,000 of
annual cash flows as there will be no debt service. To calculate the
combined cash flows from multiple years the investor would look at a
measurement called Internal Rate of Return (IRR). For the scope of
this article I will not address IRR. But remember, Cap Rate is for a
single year's return and cannot account for multiple years with
different cash flows each year.
Notice again, I haven't even spoken about appreciation which may or
may not occur. But even if no appreciation occurs to our example
property, this is still an incredible investment! Now obviously during a
25 year period these cash flows will change as rents will likely be
increased and capital improvements will likely be needed (new roof,
etc). But again, I'm keeping it simple for example purposes.
To summarize: In residential real estate there is only one way to
make money. The strategy is to carry the property and hope that the
market goes up and that the property appreciates so that the
investor can sell for a higher price than was paid. Positive cash flows
are typically non-existent and if present, negligible relative to the
anticipated appreciation the residential investment will bring.
In commercial real estate properties are purchased for their positive
cash flows AND potential appreciation. It is because of these cash
flows that commercial real estate is less risky.
It is for this reason that commercial real estate is more stable and
can weather the market storms that residential investments cannot
and it is for this reason that the super wealthy own residential to live
or vacation but invest in commercial real estate to create their
massive wealth.
Comparables "comps" are analyzed for a myriad of variables
including price per square foot, bedroom count, bathroom count,
number of garages features (pool, central vacuum, etc), location
(cul-de-sac, corner, busy street), views & more.
Adjustments are then made to the subject property to render it equal
with those comps. For instance if the subject property has one fewer
bedrooms and 500 fewer square feet of living space, it's price will be
reduced by the value of the extra bedroom and the reduced square
footage.
In commercial real estate, pricing is determined by the income the
property produces. Although physical features (pool, laundry facility,
etc) and location (busy street, etc) are factors, they are considered
only to the extent that they enable the property to command higher
rent or decrease its operating expenses in order to increase the
property's cash flows or Net Operating Income (NOI). Secondarily
location is considered to the extent of the potential appreciation of
the land. In commercial real estate, it is these cash flows and the
amount an investor is willing to pay for these cash flows that will
determine the price of the property.
Put simply, if the annual cash flows from a particular property are
$100,000 and an investor is willing to pay $2,000,000 for those cash
flows, then the property is worth $2,000,000 to that investor. If
another investor is only willing to pay $1,000,000 for those cash
flows, then the property is worth $1,000,000 to that investor.
Investors will consider numerous properties in a given area to
determine the standard of how much is typically paid for particular
cash flows in that area. The "going rate" in area can be considered
its cap rate. An exact definition and explanation of cap rate will be
detailed in a subsequent article. This article will address the concept
of cap rate.
In this example, the first investor only required a 5% return on
investment or yield and therefore could pay as much as $2,000,000
for $100,000 in annual cash flows to obtain his/her 5% desired
return. The second investor required a 10% yield and was therefore
only willing to pay $1,000,000 for the same $100,000 of cash flows.
Different investors require different yields which affect the price
ultimately paid for the property.
This one year yield could also be described as cap rate. In
commercial lingo it would be said that the second investor requires a
"10 cap" and that the first investor only required a "5 cap." This is an
oversimplified explanation to demonstrate the concept. The "one
year yield" distinction is made as cap rate only accounts for one year
yield, usually the following year from when the investor purchases
the property. To determine the combined yields of multiple year
returns, different measures are used and will be detailed in a
subsequent article.
Commercial investors will determine their risk adjusted requirements
for their investments and will base those decisions on opportunity
costs. Opportunity costs are the costs associated with not investing
into something else. For instance, if an investor could alternatively
invest in a stock, bond, T-bill CD, or other instrument and yield 15%,
why would he/she buy a property which only yields 5%? In order to
attract investors the property owner would have to lower the price
(increase the cap rate) to give investors a higher yield.
Notice the inverse relationship here. As prices are lowered, the yield
to the investor or cap rate to the investor goes up as related to the
cash flows. Conversely, as property prices are increased, the yield
to the investor or cap rate on those same cash flows goes down.
Cap rate only takes into account the first year of cash flows and
does not account for the second year, third year, etc.
Notice I have not even mentioned appreciation. The value of
commercial real estate is primarily considered based on its cash
flows while investing in residential real estate is for anticipated
appreciation.
In residential, there is only one way to make money. The market
must go up so the investor can sell for more than the original
purchase price. In commercial real estate investors are purchasing
cash flows. In our example, if the second investor paid all cash, at a
10,cap which values the property at $1,000,000, that investor would
be paid back 100% of the initial investment after 10 years and as of
the 11th year, the investor would have $100,000 of annual cash flow
from that single property. Because there is no mortgage called debt
service in commerical real estate, this would be the cash flow before
tax to the investor. In other words, other than income tax, this is the
spendable cash to the investor on an annual basis.
Hopefully the property will have appreciated as well and the market
will be favorable. But in the very worst case if no appreciation
occurred whatsoever, the investor would still enjoy the $100,000 of
annual cash flows. The beauty of commercial real estate is in the
ability to plan. If you buy a residential property, you must sit and wait
for the market to appreciate. The problem is that you never know
when this appreciation will occur or how much. You can't plan. And,
you're at the mercy of the market. In commercial real estate, as long
as rents don't decrease substantially and vacancies don't increase,
you know ahead of time how much money you will make regardless
of market appreciation.
Now consider this. Let's say that the second investor decided not to
pay cash and instead leveraged the property with a 10% down
payment or $100,000 to purchase the $1,000,000 property. Let's
also consider that the remaining $900,000 was financed at 7% for 25
years which is the typical term length in commercial financing. With a
fully amortizing loan the annual payments would be $63,000. In
commercial real estate, paying debt owed to the lender is called debt
service. In residential, it's called paying the mortgage. From the
$100,000 cash flows (NOI) from the property the debt is paid leaving
$37,000 of cash flows before tax. For simplicity sake, I will not
account for tax effects on income or yields.
In this example, in Year 1, the investor has earned $37,000 for a
$100,000 cash outlay or a 37% cash on cash return and will do so
for 25 years until the debt is paid off assuming no changes to the
income. Subsequently, the investor will enjoy the entire $100,000 of
annual cash flows as there will be no debt service. To calculate the
combined cash flows from multiple years the investor would look at a
measurement called Internal Rate of Return (IRR). For the scope of
this article I will not address IRR. But remember, Cap Rate is for a
single year's return and cannot account for multiple years with
different cash flows each year.
Notice again, I haven't even spoken about appreciation which may or
may not occur. But even if no appreciation occurs to our example
property, this is still an incredible investment! Now obviously during a
25 year period these cash flows will change as rents will likely be
increased and capital improvements will likely be needed (new roof,
etc). But again, I'm keeping it simple for example purposes.
To summarize: In residential real estate there is only one way to
make money. The strategy is to carry the property and hope that the
market goes up and that the property appreciates so that the
investor can sell for a higher price than was paid. Positive cash flows
are typically non-existent and if present, negligible relative to the
anticipated appreciation the residential investment will bring.
In commercial real estate properties are purchased for their positive
cash flows AND potential appreciation. It is because of these cash
flows that commercial real estate is less risky.
It is for this reason that commercial real estate is more stable and
can weather the market storms that residential investments cannot
and it is for this reason that the super wealthy own residential to live
or vacation but invest in commercial real estate to create their
massive wealth.
How to Value Commercial Real Estate