4 Ways to Determine the Value of an Investment Property

The value of a commercial or retail property heavily influences its operational performance, the tenants’ leasing options and the investment yield. Investors and appraisers utilize several different methods to determine the value of a property, often depending on the type of real estate, the availability of information or the goal of the investment. Gain insight into four of the most common methods below to accurately assess the value of single and multi-tenant commercial properties and maximize your profits from retail real estate leasing.

The Income Approach

The income approach is a frequently used method for evaluating a commercial property. In this situation, the value of a retail investment property relies on the interpretation of the net operating income (NOI) and the capitalization rate (cap rate). The NOI of a retail property is determined by subtracting operating expenses and vacancies from the overall potential rental income. The cap rate predicts the annual rate of return by dividing the NOI by the most recent value of the property.

By evaluating these factors, the investor focuses on recent sales and operational figures. The income approach also allows for simple adjustments to account for unique scenarios, such as likely tenant additions or scheduled maintenance.

The Cost Approach

The cost approach method considers the cost of the land plus the cost of constructing the “highest and best use” building from scratch. For example, if the piece of land is worth $100,000, and constructing a multi-tenant retail property would cost $1.2 million, the cost approach would value this commercial real estate at $1.3 million.

This approach is commonly used for new construction and vacant lots. The simplicity of the cost approach is appealing to investors and appraisers. Additionally, the cost approach accommodates for unique factors such as zoning laws to yield an accurate and current valuation.

The Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a comprehensive approach to assess a commercial or retail investment property that includes risk and opportunity cost. The CAPM considers the return on investment (ROI) on a risk-free investment, and labels it as a control, which is referred to as “beta.” Frequently-used betas include US Treasury bonds or real estate investment trusts (REITs). This valuation method is based on the comparison of expected returns between a guaranteed investment and the property in question. If the potential returns on a bond exceed those of a retail investment property, the investment isn’t financially advisable.

The CAPM assumes inherent risk and natural economic behavior that doesn’t always meet expectations. Accordingly, net lease investors find the CAPM useful for estimating the value of a property investment, understanding the approximate risks and establishing optimal tenant leasing structures.

The Sales Comparison Approach

The sales comparison approach (SCA), sometimes referred to as the market approach, utilizes prices from similar and nearby commercial or retail investment properties. This method takes the property’s general attributes into consideration and is best applied over a significant period of time. Investors and appraisers rely on the uniform metrics in this approach, such as price per square foot and recent sale price, to determine the value of the commercial real estate in question.

The SCA has the advantage of simplicity and accessibility, but often neglects the uniqueness and distinctive characteristics of a commercial property. Investors and appraisers find the SCA useful to gain insight on neighborhood pricing trends or for quick property valuations.

Interested in commercial real estate investment? Ground + Space is a leading commercial real estate brokerage firm that specializes in single-tenant and retail NNN investments. Contact us today to find out more about our current listings!


Common Cap Rate Mistakes

The capitalization rate, or cap rate, provides investors and landlords with valuable insight regarding the specifics of commercial real estate investments. If interpreted properly, the cap rate can be used by investors to compare and contrast similar investment opportunities, and landlords can include it in their decision as to whether or not to sell a commercial property. There are several instances in which cap rate can be leveraged as an effective metric, but it is often misinterpreted, misunderstood or misused. Below are the most common mistakes associated with cap rate in terms of commercial real estate investments.     

Mistakes Calculating Cap Rate

Though the cap rate formula is straightforward on the surface, its very few components, net operating income (NOI) and overall property price, are comprised of complex elements. A cap rate is often a projection of future expectations, and inaccurate NOI estimates will significantly affect the resulting percentage.

The factors involved in calculating NOI include complicated and ambiguous terms such as expected vacancy or alternate income. These pieces are influenced by an overwhelmingly large pool of external forces and can fluctuate frequently and unexpectedly. It’s imperative to precisely calculate each step of the NOI formula before determining a property’s cap rate.  

Misunderstanding Limits of Cap Rate

Cap rate should never be used as the sole deciding metric for an investment property. Countless other factors must be considered before choosing to buy or sell commercial real estate. Cap rate alone is not an effective assessment for short-term investments as it does not account for the value of potential improvements or appreciation.

Additionally, cap rate on its own does not consider the time value of money, which makes it difficult to apply to long-term investments. A cap rate serves merely as a glimpse at the one-year expected rate of return based on previous averages and should not be used for more than it’s intended.

Furthermore, cap rates are limited indicators, as they can be considered high in one market, and low in another. Location, supply and demand, types of property, types of leases and other factors all have a significant impact on the cap rate value and worth.         

Misinterpreting a High or Low Cap Rate

One of the most common mistakes investors make when interpreting cap rate is assuming that a high cap signifies a better investment. Though a high cap rate does present the opportunity for higher returns and a lower overall purchase price, it also indicates a higher risk. A property with a high cap rate may be in a less desirable location and have a higher vacancy and older amenities, whereas a property with a low cap rate is often well-managed, up to date and in a popular neighborhood with hardly any vacancies. As a general rule, a high cap rate signifies higher risk and a low cap rate signifies lower risk.

Interested in commercial real estate investment? Ground + Space is a leading commercial real estate brokerage firm that specializes in single-tenant and retail NNN investments. Contact us today to find out more about our current listings!


How to Use Cap Rate

To adequately analyze a commercial retail investment opportunity, investors often refer to the capitalization rate (cap rate) for efficient comparison. Utilizing the cap rate can be an effective method to evaluate commercial real estate as it measures the potential annual rate of return on a property.

What affects cap rate?

The cap rate is attained by dividing a commercial property’s net operating income (NOI) by the overall property price. The elements that factor into these two components can significantly affect the resulting percentage. On a macroeconomic level, supply and demand of real estate drastically affect property value and, thus, cap rate. On a microeconomic level, how business tenants operate, market themselves and make decisions can have a considerable influence on their ability to stay in business and remain reliable tenants, which affects NOI and cap rate. Other important factors that affect the cap rate of commercial retail property are the location, types of tenant leases, property type, interest rates and the overall national economic prosperity.

Measure of Risk

Both sellers and investors interpret cap rate as a percentage of risk. A low cap rate often signifies higher property value. From an investors standpoint, the potential returns on a property with a low cap rate are lower but, therefore, less risky. Commercial retail property with a high cap rate is indicative of a lower purchase price, but also a high NOI. A higher NOI increases the risk for investors as it depends heavily on the reliability of the tenants and the well-being of the economy. Additionally, sale prices can be manipulated to show more appealing cap rates.

How to Apply Cap Rate

Though landlords typically prefer lower cap rates for higher selling prices, investors prefer higher cap rates because they have a lower purchase price and higher possible returns. The way cap rate is applied and interpreted depends on the personal preference of the investor. Additionally, it’s imperative to remember that understanding the degree of risk in a commercial retail property investment is substantially more complex than merely identifying the cap rate. Several external factors can display a low cap rate one moment and a high cap rate the next.  

Due to these considerations, cap rates are best used to compare and contrast similar markets or properties. A cap rate can also serve as a practical leveraging tool in the decision to sell a commercial property. The valuable insight that cap rates provide can assist investors and landlords in their endeavors, but effective application of this information requires the help of a knowledgeable commercial retail investment brokerage.

Interested in commercial real estate investment? Ground + Space is a leading commercial real estate brokerage firm that specializes in single-tenant and retail NNN investments. Contact us today to find out more about our current listings!

 


Understanding Net Operating Income

With regards to commercial property investment, net operating income (NOI) is a critical concept for investors to comprehend. The formula includes several components that are often misread or misunderstood, however, understanding NOI is imperative to adequately gauge potential investment opportunities. Gain insight into the details of NOI to ensure a more thorough and accurate approach to your next commercial real estate investment endeavor.

What is NOI?

Net operating income is the total annual revenue produced by a commercial property after deducting operating expenses. A property’s NOI represents its ability to generate steady income and is utilized to determine the profitability and quality of potential investment. The NOI formula is comprised of several components but does not include income taxes and capital expenditures in addition to a few other minor expenses. Calculating NOI is performed using the following formula:

 Potential Rental Income

-Vacancy and Losses

     ———————————————

 Actual Rental Income

+Alternate Income

     ———————————————

 Gross Operating Income

-Operating Expenses

     ———————————————

Net Operating Income

Breaking down NOI

To calculate net operating income, it’s important for investors to understand the breakdown of each of the formula’s components. The potential rental income is the sum of the revenue that would be generated if the property was at capacity. Several different types of leases dictate rental income and subsequently affect this portion of the NOI formula, such as net leases, double net leases, triple net leases, gross leases, pass-through leases and percentage leases.

The vacancy and losses subtracted from the potential rental income include credit losses, missed payments and empty apartments or office spaces. This resulting number is called actual rental income.

The gross operating income is then comprised of the sum of the actual rental income and alternate income, which includes revenue obtained from parking, vending, laundry and other affiliated tenant services.

Once the gross operating income is determined, the final NOI number is generated by subtracting the property’s operating expenses. Operating expenses are any financial expenditures that are reasonably necessary to the function and operation of the commercial property. Commercial property operating expenses include fees, insurance, repairs, property taxes, utilities and other essential costs.

Excluded from NOI

NOI does not include capital expenditures, debt, depreciation, income taxes, leasing commissions and tenant improvements. However, some NOI calculations include different interpretations and versions of these additional expenses and, thus, thorough assessment is recommended.   

NOI Takeaway

Net operating income alone is a useful calculation of a commercial property’s current or potential profitability. NOI is used in several other commercial investment formulas, such as cap rate, which is a valuable tool to evaluate an investment opportunity and anticipate potential financial return rates. These formulas are crucial to investors looking into their next commercial real estate venture.

Interested in commercial real estate investment? Ground + Space is a leading commercial real estate brokerage firm that emphasizes personal relationships. Contact us today to find your next investment!