By Karen Hanover
The author has permitted the reprinting and redistribution of this article.
In residential real estate, pricing 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 and pricing is set. For instance if the subject property has one fewer bedrooms and 500 fewer square feet of living space, its price will be reduced by the value of the extra bedroom and the reduced square footage.
Once pricing is determined, the property is listed for sale and buyers render offers from that sale price.
In commercial real estate, pricing is established in a completely different manner. Although 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. The simplified formula for NOI is
Income – Expenses = NOI
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 must be paid for particular cash flows in that area. The “going rate” in area can be considered its cap rate. An exact definition and explanation will be detailed in a subsequent article. But for this article I can best describe the concept of cap rate through example. Here is the formula for determining cap rate
NOI Price = Cap Rate
In this example, the first investor only required a 5% return on investment or yield and was therefore willing to pay $2,000,000 for $100,000 in annual cash flows.
$100,000 $2,000,000 = 5% Cap Rate
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.
$100,000 $1,000,000 = 10% Cap Rate
This one year yield (return on investment) 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.
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 another vehicle. For instance, if an investor could alternatively invest their money in a stock, bond, T-bill CD, or other instrument and yield 15%, why would heshe buy a property which only yields 5% The answer is that the shrewd investor wouldn’t.
In order to attract investors, the property owner would have to lower the price to give investors a higher yield or cap rate.
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 those 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 in terms of figuring return on investment. 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 profit. The market must go up. In commercial real estate investors are purchasing cash flows. In our example, if the investors paid all cash, they would be paid back 100% of their initial investment after 10 years and as of the 11th year, they would have $100,000 of annual cash flows from that single property (assuming no increased rents, etc.).
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. Imagine owning just 1, 2 or 3 properties… You could quit your job, fund your retirement and live the life of your dreams!
Now consider this. Let’s say that the first investor leveraged the property and only put down a 10% deposit or $100,000 to purchase the $1,000,000 property. Let’s also assume 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 (meaning principal is paid down in addition to interest paid), the annual payments would be $63,000. This is called debt service.
From the $100,000 NOI from the property the debt is paid leaving $37,000 of cash flow before tax. For simplicity sake, I will not account for tax effects on income or yields.
$100,000 NOI – $63,000 Debt Service
= $37,000 Cash Flow Before Tax
In this example, in Year 1, the investor has earned $37,000 for a $100,000 cash outlay or 37% cash on cash return and will do so for 25 years until the debt is paid off. Subsequently, all other things remaining equal, the investor will enjoy the entire $100,000 of annual cash flows. The combined cash flows each year, in combination with the gains from sale when considered together to determine their combined yield is called Internal Rate of Return (IRR).
Even if no appreciation occurs to our example property, this is still an incredible investment with a 37% cash on cash return! This illustrates one HUGE advantage to investing in commercial vs. residential.
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 profit. 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 it’s the other way around. Properties are purchased for their positive cash flows with potential appreciation as a secondary consideration.
And, it is for this reason that commercial real estate is more stable and can weather the storms that residential investments cannot.
Imagine if you had bought 3 apartment complexes instead of those 3 homes. Where would you be now! You’d be retired with streams of income… that’s where! Invest in commercial real estate. Invest bigger! Invest better!
Karen Hanover is a Certified Commercial Real Estate Advisor and founder of the Commercial Investment Education Institute. Take a FREE Online Course at httpwww.cieinst.com
If you would like to take advantage of the market and learn how to invest in real estate and you are local to the Dallas Fort Worth area, I know a really great teacher and mentor here in Arlington Texas. Please take a look at his web site: DennisJHenson.com, Dennis has a great Mentoring and training program, I know because I am one of his former students. I learned a lot from his one on one teaching technique. – Michael Harman 817-457-7572 firstname.lastname@example.org>