Commercial Loans Blog

Commercial Loans, Cap Rates, and the "Quality" of Income

Posted by George Blackburne on Tue, Jul 20, 2021

QualityThis is the perfect time to talk about the "quality" of income.  Real estate crashes seem to strike about every ten to fourteen years, and it has been thirteen years since the Great Recession.  If we were to have another commercial real estate crash, would you rather own a building leased to Betty's Gift Shop or one leased to Amazon.com?

 

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The quality of income refers to the likelihood that you are going to receive it.  All money is green, whether it comes from the headquarters of the Catholic Church in America or from Boom-Boom's Place, LLC, a chain of gentlemen's clubs in southern Louisiana.

But is it likely that Boom-Boom's Place may have a little trouble making its rent payments or its mortgage loan payments if the economy completely tanks?  Guys are less likely to be drinking five beers a night and spending $30 on tips to the dancers if they are out of work.

Okay, obviously, we would rather be on the receiving end of $7,000 per month from Amazon.com than from Betty's Gift Shop; but in order to win that deal, we have to make some sacrifices.

 

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Amazon.com, Inc. signs a lease for a small industrial building, perhaps used to repair its delivery trucks.  Upon the execution (signing) of the lease, the owners of the little industrial building offers the property for sale.

Now normal industrial buildings in Portland are selling at, say, 6.5% cap rates.  In other words, if an investor paid all cash for a garden-vareity industrial building in Portland, he could expect to earn, after paying all expenses and setting aside a little money every year to eventually replace the roof and the HVAC system in 12 years, a return on his money of around 6.5%.

A cap rate is just the return on your money if you paid all cash for a commercial building.

 

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Before computing that return on your money, always remember that you need to set aside a little money every year to replace the roof and the HVAC system.  This is called the replacement reserve.

Okay, so the seller has a building leased to Amazon.com for $7,000 per month.  Your accountant tells you that you need to set aside $850 per month to eventually replace the roof, repave the parking lot, and replace the HVAC system.  So the investment is scheduled to yield $6,150 per month.

Since industrial buildings in Portland typically sell at a 6.5% cap rate, you compute the value as follows:  Six-thousand-one-hundred-fifty dollars per month times twelve months suggests an annual net operating income ("NOI") of $73,800.

 

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If you divide the annual net operating income (NOI) by the proper cap rate (expressed as a decimal), you get its value.

Okay, so $73,800 divided by .065 (6.5% expressed as decimal) equals a value $1.14 million.  Therefore you submit your offer of $1.14 million.  The selling broker falls out of his chair laughing.  What the heck?

"George," he says, "Betty's Gift Shop might sell for $1.14 million (a 6.5% cap rate), but this is Amazon.com!  The world could be in complete chaos, yet a buyer could absolutely depend on Amazon making its rent payments.  There are investors out there who need the security of predictable payments, and they will pay far extra to buy that stream of predictable payments."

 

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"George, I have offers on this building of $1.5 million, $1.72 million, and finally $1.85 million.  That works out to a 4% cap rate."

When a real estate and stock market crash is coming, it's all about the quality of the income.

 

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Topics: cap rate, commercial loans

Commercial Real Estate is Valued Using Cap Rates

Posted by George Blackburne on Thu, Apr 30, 2009

Cap Rate is Short for Capitalization Rate

You have probably heard the term cap rate many times, but what does it mean? Here's an easy way to understand the concept as it applies to commercial real estate. A cap rate is simply the return on your investment if you bought a commercial property for all cash.

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For example, let's suppose that you buy for $1 million an office building that is leased out to an insurance broker. The insurance broker pays you $9,000 per month in rent, but there are also expenses, like real estate taxes, insurance, property management and a small reserve where you set aside money every year to eventually replace the roof and the HVAC system. Let's assume your net operating income (NOI) is $77,000 per year.

To compute the cap rate at which you bought the building, you merely divide your anticipated NOI by your purchase price.  In this case, $77,000 divided by $1,000,000 is 0.077. To express this cap rate as a percentage, we merely multiply 0.077 by 100% to produce a cap rate of 7.70%.

In plain English, a 7.70% cap rate means that you - as a passive commercial real estate investor - will earn a 7.7% annual return on your $1 million investment in this commercial property. Please also remember that for the purposes of computing a cap rate that you should assume that the buyer did not use a commercial real estate loan to finance the property.

You can't use the same cap for every commercial property. Some commercial properties are far more desirable than others. For example, let's suppose that Microsoft Corporation was the tenant on this property, and they signed a lease for 20 years. Arguably Microsoft is one the strongest credit tenants in America. If you - as the owner of the commercial property - had a lease with a strong, credit tenant, other investors would be very envious of you. In fact, they would offer you a lot of money for this property, perhaps as much as $1,800,000.

Now remember, the net operating income is still just $77,000 per year. If you sold the commercial building to another commercial real estate investor, who wanted a very reliable income stream, for a whopping $1,800,000 - he would be buying this same commercial property for just a 4.3% cap rate. Would someone really buy a piece of commercial real estate with a cap rate of just 4.3%? Maybe ... if indeed the property was leased to a major credit tenant for twenty years. By the way, a credit tenant is usually publicly traded or a large private entity with a strong S&P rating.

On the other hand, suppose you owned an old industrial building in a seedy part of town that was leased to an auto parts manufacturer. Suppose this auto parts manufacturer sold its parts mainly to General Motors, and the auto parts company wasn't making a lot of money. Let's further suppose that the neighborhood immediately surrounding your property was filled with prostitutes and drug dealers.

Even if this property was generating the same $77,000 in net operating income, you might not be able to sell the property for very much money. Any potential buyer might think to himself, "Geesh, if I drive over to collect the rents or to check on the condition of my property, I'm putting my life in danger. Yuck." This investor might not be willing to buy the property for less than a 12% cap rate.  Seventy-seven thousand dollars divided by 12% is just $641,000.

Remember, the more desirable the commercial property, the lower the cap rate a buyer will require before he buys it.

Topics: commercial loan, commercial mortgage rates, commercial lender, capitalization rate, cap rate, commercial property loan, commercial mortgage