Peter Pays Paul

Commercial real estate is a great addition to the savvy real estate investor’s portfolio. One of my previous employers said that he would only invest in commercial real estate and not in residential. He reasoned that commercial real estate that housed a business would always be better maintained than a leased residential unit. “A business must keep up its workplace or their customer’s will stop patronizing the business.”

Commercial real estate is financed more stringently than residential real estate. Often more capital is required to invest in a commercial property than in a residential property. Most banks and institutions require a minimum of 20% of the purchase price as a down payment. This can be a hefty price with the value of many commercial properties.

Commercial income producing real estate is also valued differently. Residential real estate is valued by the price the market will bear. A home is much more of a commodity than it is unique (though this contradicts much teaching in real estate textbooks). Not many people are willing to pay $50,000 more for a house, if the exact same house with the same features is available next door for less. Hence, the value of a home is much more a product of the supply of like homes, and the demand for those same homes.

Unlike homes, commercial real estate (CRE) is often valued by the income it produces. CRE, for the most part, is viewed as an investment. Owners want a return on the money that they invest in the project. The value of CRE is derived from the rental income from tenants.

Often a capitalization rate (cap rate) is used to value the property. The cap rate is a measure of the return on the purchase price of the asset. Capitalization rates vary from geographic area to geographic area and are directly related to the amount of perceived risk. Areas with high vacancies or other problems command a higher capitalization rate. More stabilized rentals with fewer problems often are capitalized at a lower rate. In many parts of the country a cap rate from 6-8% is used. Currently, in San Francisco a cap rate in the 4-5% range is common, due to high home prices and a high demand for rental units.

The cap rate is calculated by dividing the properties net income (not gross see note below) by the value or cost of the property. So, a property that costs $125,000 and generates $10,000 in net income would have a cap rate of 8%.

By reversing the formula above, knowing the appropriate cap rate, you can determine the value of an income producing property based on the net income the property produces. This is done by dividing the current net income by the cap rate. For instance a property that generates $10,000 in net income divided by a cap rate of 8% produces a value of $125,000.

By changing the formula again we can determine the assumed net income for a property based on the asking price.

Other factors like property condition, location, and tenant characteristics may increase or decrease the cap rate. All these factors should be taken into consideration when determining the appropriate cap rate to use for a given geographic area. I recommend using a knowledgeable, experienced, and local commercial broker to help you determine appropriate cap rates and property values.

Commercial income property is a solid investment for the long term. Commercial real estate should generate consistent income over the life of the asset. Many savvy investors use commercial income properties to generate income during their retirement years. Investment in this type of property requires due diligence and capital. However, for the savvy investor with the right investment team it can be a powerful wealth builder.

Note: It is very important to base these calculations on the net income of the property and not the gross income. It is also important to verify the net income figures through the use of a rent roll, copies of the leases, and the previous two years’ expenses. Unfortunately, unscrupulous persons have been known to increase actual rental income and to decrease actual expenses to increase the net income in order to command a higher property value.

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