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It’s All About The Numbers

The value of commercial real estate is driven by numbers. There’s little or no emotion in it.

The closest thing to an emotional buyer would be an owner/user who becomes attached to a property as a homeowner would. Other than that, value is driven by rents, and of course location.

These two things are inextricably connected. Astronomical prices for property in midtown Manhattan are certainly supported by astronomical rents, but the location attracts investors willing to wait much longer to recoup their capital, which drives prices up further. So, location can play a huge role in valuations, just as in residential. Another factor in valuation is the quality of the tenant. An “anchor” tenant, such as Walmart, dramatically lowers risk for adjacent property and increases value.

This dynamic is captured with a metric called the “CAP” rate, or capitalization rate. The CAP rate measures how fast an owner gets paid back, from income, for the purchase, and is expressed as a percentage. So, a “12 CAP” on a $1M purchase would recover the full purchase price in 8.3 years ($1,000,000 x 12% = $120,000/yr). A “7 CAP” would take 14.3 years, which translates into higher value, higher price, but lower risk. A property on 5th Avenue may have a CAP rate of 3 or 4 because a buyer expects to own it for a very long time, and might enjoy huge capital appreciation and income in the process. As a general rule, a better location pushes up value but lowers risk.

There must be net income to determine a CAP rate. No income, no CAP rate. The net income is the gross rent less expense and is referred to as “NOI” or Net Operating Income. This key number is where opportunity exists, and pitfalls too. Owners who aren’t diligent with their books can muddy the waters on getting a clear view of the bottom line. Maybe they’ve commingled personal funds or neglected “deferred maintenance” that lowers value.

Conversely, a clear financial picture may reveal below-market rents, which means a lower price for a buyer and value appreciation when rents are raised to near or at market levels. Once you have a solid NOI number, the CAP rate is chosen by surveying prevailing CAP rates in the area, which will usually give you a narrow range to work with. Divide the NOI by the CAP rate, and Voila – you have the value of the property!  So, a building generating $100,000 in NOI, at a 7 CAP would be valued at $1,428,571.

It’s all about the numbers!

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