How to value commercial real estate 101


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the basics on how to value commercial real estate. Focusing on CAP rates, GRM, and other basics of commercial real estate investing.

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How to value commercial real estate 101

  1. 1. Evaluating Commercial Properties 101 Presented by Curtis Gabhart and David Stankaitis, CCIM
  2. 2. Overview Value of Property: What is it and how is it determined? Getting to the NOI Ok, so I have the NOI, now what? CAP, GRM, CPU, Cost per SF Lending Basics Leverage, LTV, DSCR Cash on Cash Return (ROI) Review Q&A
  3. 3. Value of Property  Definition: The most probable price (in terms of money) which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.
  4. 4. Value of Property, cont’d As an investor, value is related to the specific purpose for which you have purchased a particular property. For our purposes, we are going to say that value is the present value of the projected future income stream or benefits that you expect to obtain.
  5. 5. Value of Property, cont’dIncome properties produce income that provides astream of cash sufficient to: • Cash flow not only covers all expenses, but reduces the debt necessary to acquire the property; and • Give you a return of your investment plus a return on your investment. • Even if the investor chooses to use the property themselves and pay the necessary operating expenses, taxes and maintenance themselves, the value of the property is what it would have cost them to obtain a comparable property as an investor.
  6. 6. Value of Property, cont’dCash Flow analysis for real estate investments follow a very specific format: Gross Scheduled Income (Minus) Vacancy and Collection Loss (equals) Effective Gross Income (minus) Operating Expenses (equals) Net Operating Income The format above does not change, regardless of the type of property. Therefore, it is important that the practitioner be familiar with the formula, as well as the definition of each.
  7. 7. Gross Scheduled Income: The sum of the expected rent for a particular property. e.g. In an Apartment building it would be the sum of the rents from each apartment.Vacancy: Is calculated as the rent loss due to empty units. When underwriting the lenders usually use 5% or the market vacancy factor.
  8. 8. Effective Gross Income:Is the difference between the GSI and Vacancy Factore.g. If Gross Scheduled Income is $100,000 and vacancy is 5% what is the Effective Gross Income? GSI $100,000.00 Vacancy $ 5,000.00 EGI $ 95,000.00
  9. 9. Expenses• T-U-M-M-I• Taxes• Utilities• Management• Maintenance• Insurance
  10. 10. Net Operating IncomeGSI $ 100,000.00Vacancy $ 5,000.00EGI $ 95,000.00ExpensesTaxes $ 15,000.00Utilities $ 3,450.00Management $ 5,000.00Maintenance $ 5,000.00Insurance $ 5,000.00Total Expenses $ 33,450.00Net Operating Income $ 61,550.00
  11. 11. Pricing Summary Calculating the Comparable Benchmarks  CAP  GRM  CPU  Cost per Square Foot
  12. 12. Capitalization Rate– The methodology using Capitalization (CAP) rates to derive value is known as Direct Capitalization. Symbolically, CAP = NOI / Price– For example, if within a specific submarket properties have recently traded at a 10% CAP rate and a property has an NOI of $150,000, you can derive a preliminary value estimate of $1,500,000 by dividing $150,000 by 0.10.
  13. 13. Capitalization Rate Cont’d• If the NOI were $100,000 what is the property worth at a 6% CAP? 7% CAP? 8% CAP?• $100,000 / 6% = $1,666,667• $100,000 / 7% = $1,428,571• $100,000 / 8% = $1,250,000
  14. 14. Capitalization Rate, cont’d• A warning about CAP Rate: • Be careful with the term "CAP Rate". Advertised rates will vary depending upon the method of calculation. For example, CAPs can be based on: – Actual income and expenses from the prior 12 months, – Projected income and last years expenses, – Projected income and last years expenses inflated by 3.0%, – Current income and projected expenses, – Projected income and expenses, – And for each of these, NOI can be calculated before or after reserves. – Click here for more in depth information on CAP RATES
  15. 15. Gross Rent Multiplier Another method of valuing an income steam is known as the gross rent multiplier (GRM). – Sometimes it is also referred to as the gross income multiplier (GIM). This method simply compares the value or sale price of a property to its gross rental income. The gross income that is used will always be gross income, but it may be figured on an annual or a monthly basis. In most cases, the monthly gross rents will be used in small residential properties almost exclusively.
  16. 16. Gross Rent Multiplier, cont’d Regardless of which type of gross income is used, the calculation is the same. – The formula is: Value = Gross x GRM This factor must be derived from analysis of comparable property sales. – For example, in analyzing a small residential investment property with a gross annual income of $12,500. a search of comparable sales indicates the following data;
  17. 17. Gross Rent Multiplier, cont’d The gross rent multiplier for each property may now be calculated Value Gross Income GRMSale 1 $125,000 $19,600 6.38Sale 2 $164,000 $26,100 6.28Sale 3 $110,000 $17,100 6.43Sale 4 $130,000 $20,000 6.5Sale 5 $182,000 $30,000 6.07
  18. 18. Cost Per Unit Cost per Unit is a simple market benchmark, derived by dividing the price by the number of units. Conversely, you derive the price by multiplying the number of units in a building by the current market price per unit.
  19. 19. Cost Per Unit Cont’dValue Units CPU $1,000,000 8 $125,000 $1,000,000 10 $100,000 $1,000,000 12 $83,333
  20. 20. Price Per Square Foot The price per square foot is derived by dividing the price of the property by the square footage.
  21. 21. Price Per Square Foot, cont’d Value S.F. PPSF $1,000,000 3,300 $303.00 $1,000,000 10,000 $100.00 $1,000,000 2,000 $500.00
  22. 22. Weaknesses of the Indicators The price per unit does not consider the size, type of units, income or physical condition. The price per sq. ft. does not consider the number of units, the type of units, the income or physical condition. Gross Rent Multiplier considers only the Gross Potential Rent (GPR), not the vacancy, expenses, physical condition or the potential upside due to below-market rents. The CAP Rate considers the net income but not the impact of the financing or the potential upside due to below-market rents.
  23. 23. Leverage, cont’dThe principal of using leverage to your advantage can be illustrated fairly simply. – If you were to invest $100,000 and receive a return of $10,000, then you would have received a 10% rate of return ($10,000 return divided by $100,000 initial investment).
  24. 24. Leverage, cont’d What if, on the other hand, you were to make the same $100,000 investment, at the same return, using only $10,000 of your own money while borrowing the balance required from somebody else? The return on your investment (not counting interest on the loan) would be 100% ($10,000 return divided by $10,000 initial investment). This is a simplified example but shows the dramatic effect leverage can have on total return.
  25. 25. Loan to Value (LTV)• The maximum loan amount a lender is willing to lend expressed as a percentage of the value.• e. g.75% LTV means the maximum amount a lender will loan is 75% of the value (or purchase price).• If the purchase price is $2,500,000 and the max LTV is 65% what is the maximum Loan Amount?• $2,500,000 * 65% = $1,625,000
  26. 26. Debt Service Coverage Ratio (DSCR)• DSCR is a ratio used by the lender to provide an income “cushion” to limit loan amount.• The larger the DSCR the greater the perceived risk by the lender• If you are told the DSCR is 1.30:1.00, what does this mean?
  27. 27. Debt Service Coverage Ratio (DSCR) cont’d• The Net Operating Income must be 130% or 1.3 times greater than the annual debt service payments.• e.g. If the annual debt service were $100,000 and DSCR were 1.30 to 1.00 what is the NOI?• $130,000
  28. 28. Debt Service Coverage Ratio (DSCR) cont’d• What about the other way? If my NOI is $100,000 and DSCR is 1.30:1.00 how much do I have for debt?• $100,000 / 1.30 = $76,923
  29. 29. Debt Service Coverage Ratio (DSCR) cont’d• $100,000 / 1.30 = $76,923• If the rate is 5% and the amortization is 25 years, how much can I borrow?• $76,923 / 12 = $6,410 = monthly payment• Solve for Present Value = $1,096,495
  30. 30. Debt Service Coverage Ratio (DSCR) cont’d• Purchase price is $1,000,000, NOI is $65,000, maximum LTV is 75%, interest rate is 6%, amortization is 25 years, and the DSCR is 1.25 to 1.00, how much can be borrowed?1. $65,000/1.25 = $52,0002. $52,000 / 12 = $43333. Solve for PV = $672,511 or 67% LTV
  31. 31. Cash on Cash Return• Some may refer to this as Return on Investment or ROI• ROI = Cash flow after debt service/Investment• Let’s use the previous example to determine investment amount ($1,000,000 with max LTV of 67% = $330,000 investment.• What is the ROI or Cash on Cash if there is no debt?
  32. 32. Cash on Cash Return cont’d• NOI = $65,000• Annual Debt Service = $52,000• Investment = $330,000• ROI = ($65,000 - $52,000)/$330,000 or 3.94%
  33. 33. Review• If the NOI is $150,000, the expenses are 35% of EGI, and the vacancy factor is 7% what is• A) The Effective Gross Income?• B) The Gross Scheduled Income?• C) If the CAP is 8% what is the purchase price?• D) What is the GRM given the 8% CAP?• E) Assume a 1.30 to 1.00 DSCR, a rate of 5%, 30 year amortization, and a maximum LTV of 75%, what is the maximum loan amount?
  34. 34. Review Cont’d• A) EGI = $150,000 / 65% = $230,768• B) GSI = $230,769 / 95% = $242,914• C) $150,000 / 8% = $1,875,000• D) GRM = $1,875,000/$242,914 = 7.72• E) 150,000/1.3 = $115,385 $115,385/12 = $9615 Solve for PV = $1,791,078 =95% LTV Max LTV is 75% or $1,406,250
  35. 35.