Introduction
What most distinguishes an investment asset from a speculative asset is the comparison of price vs. appraised value. To an investor, the comparison of price and value is the most important consideration. It is only fitting, then, that I devote a post in this series to the valuation of commercial property.
Before I go further, I should note that this blog series will focus on investing in existing commercial properties. Bottom-up real estate development and substantial redevelopment are different endeavors deserving of their own treatment. I’ll tackle those subjects in time, but for now I’m going to assume that the property contains physical structures and is more or less tenant ready.
There are three primary methods for valuing commercial property: the sales comparison approach, the replacement cost approach, and the income approach. Although the first two valuation methods can be important supplementary measures, we will focus on the income approach. After all, investors are not so much concerned with buying a building but in buying the income stream that the property will produce.
There are two variations of the income approach which we will examine in this post. The first is a common shorthand valuation known as the income capitalization approach. With this approach, the investor values the property by dividing the current income by a rate comparable with the rate on competing properties and investment alternatives with similar risks. The second method involves estimating individual yearly cash flows over the expected holding period and discounting those cash flows individually.
Valuing Property Using the Income Capitalization Method
The most common way to value commercial properties is to “capitalize” the property’s expected income stream. With this method, the two key variables are net operating income and the capitalization (“cap”) rate.
Net operating income (NOI) is the lifeblood of any commercial property, as it represents the amount of income available to pay debt costs, distribute cash to equity investors, and make capital improvements.
To calculate NOI, we begin with potential gross income. This is the lease revenue which we collect from tenants, assuming that the entire property is leased, plus any other income which the property may produce. Of course, most multi-tenant properties will have some vacancies, on average, so we must subtract a vacancy allowance. Subtracting the vacancy allowance from the potential gross income gives us the property’s effective gross income.
To go from effective gross income to net operating income, we must subtract the property’s operating expenses. The operating expenses include things like property insurance, management fees, repairs and maintenance costs, and utilities. The specific items included in operating expenses will depend on how the leases are structured – in many leases, the tenants are responsible for many of these costs.
NOI does not include interest expense, property depreciation expense, income taxes, or capital improvements. NOI is thus the property’s operating income available for both equity investors and debt providers, on a pretax basis.
When valuing property, the NOI figure that we are most concerned with is the proforma NOI for the next year. The term proforma refers to certain adjustments we must make to the historical property financials. For example, the current owner may have neglected maintenance costs, or property insurance rates are about to increase significantly. In any event, we are interested in future income, and the historical financials are merely a guide to calculating that figure.
When we use the NOI capitalization approach, we are effectively valuing the property as a growing perpetuity. A perpetuity is a perpetual income stream. A growing perpetuity is a perpetual income stream that is expected to grow at a constant rate, year over year. When investing in a commercial property, we would expect (or at least hope) that NOI would grow in-line with inflation, and possibly a percentage or two above that.
Property value = NOI / (r – g)
Thus, the cap rate is the investor’s required rate of return (r) minus the expected yearly growth rate in NOI (g). For example, suppose that our required rate of return is 12% and we expect NOI to grow at a constant rate of 3% per year. The cap rate we would use is thus 9% (12% – 3%). In practice, the cap rate is derived from recent transactions on similar properties.
Let’s put this together with an example. Suppose that we are looking at a small shopping center. We estimate that next year’s NOI will be $125,000. The average cap rate for similar properties sold within the last six months is 8%. The property value based on these two variables is:
$125,000 / .08 = $1,562,500
Valuing Property Using the Discounted Cash Flows Method
With the discounted cash flow method, we value a commercial property by summing the discounted value of each individual cash flow over our expected holding period. The discounted cash flow method is particularly useful when income is expected to grow at an above-average rate for some time before settling into a more sustainable growth rate.
Discounting is a mathematical operation in which we calculate the present value of a future amount. To discount the individual cash flows, we multiply each cash flow by a discount factor. We can calculate the discount factor by (a) adding 1 and the discount rate, (b) raising this amount to the number of years we are discounting, and (c) dividing 1 by this amount.
For example, suppose that we expect to hold a property for five years and our required rate of return is 12%. The discount factor for each year is:
Discount factor for year 5 cash flow = 1 / [(1.12)^5)] = 0.5674
Discount factor for year 4 cash flow = 1 / [(1.12)^4] = 0.6355
Discount factor for year 3 cash flow = 1 / [(1.12)^3] = 0.7118
Discount factor for year 2 cash flow = 1 / [(1.12)^2] = 0.7972
Discount factor for year 1 cash flow = 1 / [(1.12)^1] = 0.8929
From a valuation standpoint, we define property cash flows as NOI minus a provision for capital improvements. Capital improvements are those expenditures made to enhance the value of the property and are not included in the calculation of NOI. In the last year of the holding period, the cash flow will include both the operating cash flow in that year and the estimated sales price.
For example, suppose that we are looking to buy a commercial property. Our expected holding period is five years. Our estimate for NOI in the next year is $100,000 and is expected to grow at 5% per year for each year of the holding period, and 3% per year after the holding period. We estimate that capital improvements will require an average of $8,000 per year over the holding period. We estimate that we can sell the property at the end of year 5 at a cap rate of 8%. Our required return is 12%. How much would we be willing to pay for this property?
The first thing we should do is to estimate the operating cash flow for each year of the holding period.
Year 1 operating cash flow = 100,000 – 8,000 = 92,000
Year 2 operating cash flow = (100,000 x 1.05) – 8,000 = 97,000
Year 3 operating cash flow = (100,000 x 1.05^2) – 8,000 = 102,250
Year 4 operating cash flow = (100,000 x 1.05^3) – 8,000 = 107,763
Year 5 operating cash flow = (100,000 x 1.05^4) – 8,000 = 113,551
In year 5, we’ll also have the cash flow from the sale of the property. We think that we can sell the property at an 8% cap rate. The next year’s (year 6) NOI is 121,551 x 1.03 = 125,197. At an 8% cap rate, the expected sale price is 125,197 / .08 = $1,564,963. However, we’ll also have disposition costs, such as brokerage commissions, legal fees, etc., which will have to be paid out of the sale proceeds. Assume that we expect disposition costs to equal 7% of the sale price. In that case, expected pretax sales proceeds are $1,455,416.
Applying the discount factors that we calculated before, the present values for each of the cash flows are:
Year 1: 92,000 x 0.8929 = 82,147
Year 2: 97,000 x 0.7972 = 77,328
Year 3: 102,250 x 0.7118 = 72,782
Year 4: 107,763 x 0.6355 = 68,483
Year 5: (113,551 +1,455,416) x 0.5674 =890,232
The preset values sum to $1,190,972; this is the amount that we would be willing to pay for this property.
We can also use this valuation to calculate an implied cap rate. We simply divide the discounted cash flow value by the first year NOI: $100,000 / $1,190,972 = .084 = 8.4%. We can then compare the implied cap rate against comparable sales as a check on our assumptions in the DCF valuation.
The scenarios above are simplified examples of the type of “first pass”, property-level financial valuations that commercial real estate investors perform. This level of analysis ignores the effects of financial leverage (borrowed money) and taxes, both of which are considered in later stages of commercial real estate analysis.
In the rest of this series, we will consider how commercial real estate investors conduct due diligence and obtain financing.
Leave a Reply