Commercial Real Estate Investing For Dummies. Peter Harris
All leases are triple net (NNN), with the owner charging the tenants for common area maintenance (CAM). The CAM expense for the owner is $3,000 per month and includes landscaping, parking lot, hallways, and restrooms.
Now, you need to separate this whole deal into its three simple components of income, expenses, and debt. Here’s the income breakdown:
Gross income = $287,000
For the expense breakdown, because this is a triple net lease, the tenants pay all property operating expenses. The landlord initially pays for all common area maintenance (CAM) expenses, but then the CAM expense is billed back to and divided among the tenants. That's why there’s no expense listed here as a cost to the landlord.
To figure the debt breakdown, you need to figure out what the yearly loan payments would be. We’re going to assume that the interest rate is 6.5 percent today with a 30-year amortization period:
Asking price = $3,100,000
Down payment = 20 percent of asking price, which is $620,000
Loan amount (principal) = $3,100,000 – $620,000 = $2,480,000
Loan payment per month = $15,675 (we used a mortgage calculator for this figure)
Loan payments per year (debt service) = $15,675 × 12 months = $188,100
Now, you have everything you need to figure out whether this deal makes money, using these four easy steps:
1 Calculate the net operating income (NOI).Net operating income = effective gross income – operating expenses$287,000 – $0 = $287,000
2 Calculate the cash flow.Annual cash flow = net operating income – debt service$287,000 – $188,100 = $98,900
3 Calculate the cash-on-cash return.Cash-on-cash return = annual cash flow ÷ down payment$98,900 ÷ $620,000 = 16 percent
4 Calculate the cap rate.Cap rate = net operating income ÷ sales price$287,000 ÷ $3,100,000 = 9.3 percent
That’s a pretty decent return on your investment, and it’s pretty hands-off compared to being involved with managing a property every day.
Valuing Properties like a Professional
Professional property evaluators, commonly called real estate appraisers, have the awesome responsibility of estimating or giving an opinion of a value on commercial properties. It makes sense for you to understand how appraisers value commercial real estate so you can apply their techniques to our methods of estimating value.
Approach #1: Comparable sales
The first and easiest method in commercial property evaluation is called the comparable sales approach. If you've bought a house before, you may remember the bank had an appraiser go out and give the property a value that you hoped at least equaled your purchase price. Well, the same applies here for commercial property. The commercial appraiser goes out and compares prices of recently sold local properties that are similar in form and function to the property he’s appraising. The comparison will produce an average price, and that price is what your property will be valued at. But in commercial comparables, instead of looking at just overall sales price, the sales price per square foot of the building is also considered one of the main factors.
Here’s a quick example:
Property A, a 10,000-square-foot building, sold last spring for $65 per square foot. Doing the simple math to compute the sales price, you calculate 10,000 square feet × $65 per square foot = $650,000.
Property B, a 9,000-square-foot building, sold three months ago for $68 per square foot. Again, doing the math, 9,000 square feet × $68 per square foot = $712,000.
Property C, the property you want to figure a price for, is similar to Property A and Property B and is 11,000 square feet in size. If you average out the price per square foot on both Property A and Property B, the average comes out to $66.50 per square foot. Use that price per square foot as your number to evaluate Property C. Doing the math, you get 11,000 square feet × $66.50 = $731,500 as the value for Property C.
Even though the comparable sales approach is the easiest method for figuring out a value for a commercial property, it can be flawed. We’ve run into a couple of problems when using this approach.
Approach #2: Income
When you get out into the real world of commercial real estate, you’ll discover that commercial properties are chiefly valued by the amount of income they bring in. (That's why they're called income properties!) To be more precise, it’s the net operating income that’s most important.
The income approach of valuing a property can be used when accurate financial and operating data are available on the property. This approach is based on the capitalization rate being calculated for a property. To calculate the cap rate, you must know the property’s net operating income and sales price.
After you calculate the cap rate of a property, the next step is to compare the cap rate to similar properties’ cap rates. Every area in your city that has commercial properties has a cap rate stamped on it. Your job is to find those other properties and their cap rates and get the average. That average cap rate percentage is what you use in calculating property value when you know the net operating income.
Take a look at this example: You want to value a 50-unit apartment building. You calculate the net operating income to be $180,000. Your research from previous apartment sales tells you that the going cap rate for the neighborhood in which the property is located is 8 percent. Now, if you know the net operating income and the cap rate, you can figure out the sales price. Here’s how:
Cap rate = net operating income ÷ sale price
7 percent = $180,000 ÷ sale price
Sale price = 180,000 ÷ 7 percent = $2,571,428
Now you know that the property should be valued at or estimated to be $2,571,428, based on average cap rates in the area and the property’s net operating income. We love dealing with numbers in the millions. At times it feels like we're playing Monopoly!