This is my 4th blog article on the subject of cap rates and commercial loans, and its a good one! Today you will learn how appraisers and commercial brokers (commercial realtors) compute a cap rate. Then you will learn how to appraise or value a commercial property using a cap rate.
A Pro Forma Operating Statement is a projected budget for a commercial property for the upcoming year. A pro forma sets aside a reserve for vacancy and collection loss and a reserve for replacements (new roof, new HVAC unit, etc.). It also budgets for outside management, even if the owner currently manages the property. The bottom line of the pro forma is the commercial property's projected Net Operating Income (NOI). We will use the NOI a lot in this article.
When an appraiser wants to figure out the cap rates at which nearby commercial properties are selling, he starts first by by gathering up the offering memorandums on recently sold commercial properties. By the way, an Offering Memorandum is a sales brochure, prepared by the listing real estate broker, that describes the commercial property that is for sale, includes color pictures, and contains a pro forma operating statement on the property. Please be sure to look at the sample offering memorandum.
From the offering memorandum, the appraiser gathers the Net Operating Income number. Using the NOI and the actual sales price, the appraiser can quickly compute the cap rate.
How exactly does he do this? Well, let's look at the definition of cap rate.
Cap Rate = (NOI / Purchase Price) x 100%
For this example, let's assume that the appraiser looked at the original offering memorandum of a recently-sold 8-unit apartment project and plucked off the number, $48,619, as the NOI. The building eventually sold for $1,055,000. Let's plug, chug, and then compute our cap rate:
Cap Rate = ($48,619 / $1,055,000) x 100%
Cap Rate = .046 x 100%
Cap Rate = 4.6%
In other words, if an investor purchased this 8-plex for $1,055,000 all-cash, and if he hired a professional management company to run the property, the investor would earn an annual return (think of it like "interest") of 4.6%. This is a fairly low cap rate, but apartments are a very desirable form of income property, and this particular 8-plex was located in a densely-populated, high-demand area of Sacramento.
Okay, now let's look at a different property. Suppose you're the appraiser or a commercial real estate broker. You have looked at the numbers on a dozen nearby commercial properties that have sold recently and which are comparable to the retail building (lets say a dollar discount store) that you are trying to value today. You have computed the cap rates on these dozen sales, and you have determined that small, free-standing retail buildings in this area sell for a cap rate of around 9.25%.
You have also looked at the lease and the historical operating expenses for this dollar discount store building, and using those numbers, you have prepared a pro forma operating statement. You have computed the projected NOI to be $32,500 per year.
Now here comes your biggest nightmare. Do you remember when your high school algebra teacher once said, "You're going to have to learn this stuff. You will need to use algebra someday in business." Well, folks, unfortunately today is that day; but I promise to go slow and to use baby language. And please don't panic! When I'm done, I am going to give you a simple formula that you can memorize to figure out the value of a commercial property.
Now let's first key our eyes on the target. We are trying to value a little free-standing retail building that is currently leased to a dollar store. We know the property's NOI, which we computed to be $32,500 per year. We know at what cap rate comparable commercial properties are selling - 9.25%. So how do we use what we know to compute the property's value? Let's start with the definition of a cap rate.
Cap Rate = (NOI / Purchase Price) x 100%
In order to solve for Purchase Price (Value), we have to rearrange the equation to where we have "Purchase Price is equal to" on one side of the equation. Therefore we are going to have to move some terms around to isolate Purchase Price on one side of the equal-to-sign.
Now, remember, in algebra we can do anything we want to one side of the equal-to-sign, as long as we do the same thing to the other side. Let's start by multiplying each side of the equation by Purchase Price.
Purchase Price x Cap Rate = (NOI / Purchase Price) x Purchase Price x 100%
What is seven divided by seven (7/7)? One, right? What is (9.2 / 9.2)? One, right? What is (Purchase Price / Purchase Price)? One! So now let's rewrite this equation:
Purchase Price x Cap Rate = NOI x 100% x (Purchase Price / Purchase Price)
Purchase Price x Cap Rate = NOI x 100% x 1
Purchase Price x Cap Rate = NOI x 100%
We are trying to isolate Purchase Price on one side of the equal-to-sign, so now let's divide both sides of the equation by Cap Rate.
Purchase Price x (Cap Rate / Cap Rate) = (NOI x100%) / Cap Rate
Purchase Price x 1 = (NOI / Cap Rate) x 100%
Purchase Price* = (NOI / Cap Rate) x 100%
*Another name for Value.
This formula in red is the one you can simply memorize. You take the property's NOI and divide it by the Cap Rate (expressed as a decimal; i.e., 0.072 rather than 7.2%).
Okay, we're now ready to plug and chug. In this example we assumed that the proeprty's Net Operating Income (NOI) was $32,500 per year. We also determined that comparable commercial properties nearby were selling at a 9.25% cap rate (0.0925 if expressed as a decimal).
Value = NOI / Cap Rate**
** Please note that we had substituted Value for Purchase Price and that in this formula we have to remember to express the Cap Rate as a decimal.
Value = NOI / Cap Rate
Value = $32,500 / 0.0925
Value = $351,351 or rounded to $351,000
Forget about the torturous algebra! Just remember to divide the Net Operating Income by the Cap Rate (expressed as a decimal) to figure out the value of the property.
This is such an important tool that we are going to do one more example. The subject property is an office tower in Indianapolis generating $2,324,000 per year in net operating income. Similar office towers downtown are selling at 6.75% cap rates.
Value = NOI / Cap Rate
Value = $2,324,000 / 0.0675*
Value = $34,429,629 rounded to, say, $34,430,000
* Would you have remembered to convert the cap rate to a decimal format?
Congratulations! You now know how to value a commercial property, even one that is located in Bum Flowers, Egypt. :-)
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