Commercial Loans and Fun Blog

Commercial Loans, Golf Courses, and Cap Rates

Posted by George Blackburne on Mon, Aug 2, 2021

Screen Shot 2021-08-01 at 6.18.20 PMThis is a fascinating story of how using a cap rate allowed us to value and sell a foreclosed golf course, and it helped my private investors avoid a loss and actually make a profit.

There are three methods of valuing income property - the cost approach, the sales comparison approach, and the income capitalization approach.  When the appraiser has arrived at a value using each approach, he then has to reconcile these three valuations to arrive at his final conclusion.


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It is important to note that the appraiser must not just average the three results.  Instead, the appraiser should choose the most reliable approach to value and then temper that conclusion with the results of the two other approaches.

Now when valuing a fairly standard property type, like an apartment building, appraisers tend to rely the most heavily on the sales comparison approach.  For how much have other apartment buildings in the area sold?

Since there are bazillions of apartment buildings, the valuation process is generally straight forward.  How much did nearby apartment buildings sell for per door?  (Fancy CREF way of saying "per unit.")  What was their gross rent multiplier?


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The cost approach is the valuation method least often used, mainly because it is too much work for appraiser.  Too often the appraiser just weenies out of using the cost approach, citing the bull stuff excuse that it is too difficult to "estimate depreciation."  

But now the tale gets juicy... and dark.

About four years ago, Blackburne & Sons made a $2.75 million loan on a gorgeous golf course in an affluent suburb of Chicago, a golf course course with a replacement cost of $13.2 million (according to the county).  Unfortunately the borrowers defaulted, and we foreclosed.


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At first, the real estate brokers were telling us that our golf course was almost worthless.  Several thousand golf courses had already come back in foreclosure nationwide over the past decade, as Tiger Woods self-destructed and the sport waned in popularity. 

"This golf course sold for just $2 million," the real estate brokers would tell us  "This other one sold for only $1.5 million - about the value of Midwest farmland."

But wait a moment, we reasoned.  Those golf courses were all losing money.  They had lost money for a decade.  Our golf course was actually profitable.  (Our borrower had simply been over-leveraged.)

Those foreclosed golf courses were also located in inconvenient, middle-income areas.  The folks living in the surrounding neighborhoods of those foreclosed golf courses were mostly blue-collar folks who didn't make nearly enough money to join a golf club.


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Far more importantly, however, the "sales comps" were all sales where the seller had a gun to his head.  Think back to the movie, The Godfather.  That movie producer did NOT want to to cast Jonny Fontaine (Frank Sinatra) in his movie... until he woke up to find the head of his beloved horse under the sheets of his bed.

Folks, you cannot use as a sales comparable a sale where the seller was just 48 hours from foreclosure.  Part of the definition of fair market value is the proviso that ... "neither the buyer nor the seller was under undue pressure." 

Okay, so we can't use foreclosure sales, REO sales, and sales on the cusp of foreclosure as sales comparable's.  These sellers were all under undue pressure.


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But what do we do when very few profitable golf courses have sold in the preceding three years?  There were simply no un-pressured sales to use as comp's.

This is when I personally stepped in and started marketing the golf course based on the income approach.  "Buy this Course and Earn a Whopping 9.75% Cap Rate!"  You will recall that a cap rate is just the return on his money that a buyer would earn if he paid all cash for an income property (allowing for about 3% of Effective Gross Income to replace the roof and the HVAC units as they got tired).

Holy moly!  The course sold for $3.2 million within just 10 days of marketing. Prior to that, our idiot real estate broker was telling us that we had to sell this trophy golf course for just $1.6 million.  The real estate broker was a moron to rely entirely on the sales comparison approach to value.


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I personally hope the deal falls through because the net profit to our golf club just keeps skyrocketing.  If we had waited just six more months, I am convinced that we could have sold the course for $4.8 million.

The lesson to be learned today is that the sales comparison approach is NOT the only way to value real estate.  People buy income properties for the income they generate.

By the way, I begged the buyer to allow me to buy part of the course based on that paltry $3.2 million purchase price.  I suspect that he laughed at me.  Clever boy.


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Topics: Cap Rates, golf courses, commercial loans

Valuing Commercial Properties Using a Cap Cate - Vet Clinic Example

Posted by George Blackburne on Thu, Jul 29, 2021

Screen Shot 2021-07-29 at 1.31.55 PMThis may be the most instructive training article that I have written in several years, so I strongly encourage you to study it.  (Note: This is NOT the subject vet clinic.)

Sometimes in the commercial loan business, you have to value a property based strictly on a capitalization rate ("cap rate").


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Several years ago, I took on a commercial loan on an owner-occupied veterinary clinic.  The vet had gone through a divorce, and he had been forced to file for bankruptcy three years earlier.  He could therefore not qualify for a SBA loan.

The property was located in a town of over 75,000 people, so he could not qualify for a USDA business and industry loan either.  USDA B&I loans are very similar to SBA loans; but they are designed for rural areas.  Any town with a population of 50,000+ people is not considered sufficiently rural.

The loan had to go to a bank or credit union, so I was forced, absent an appraisal (always let the bank order the appraisal), to somehow create a pro forma operating statement on an owner-occupied veterinary clinic.  Hmmm.  How could I do that without having any idea of the market rent of a vet clinic?  Here is what I came up with, and I must say, it was brilliant.


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I knew that the vet had bought the facility for $500,000 two years earlier.  To add in some property appreciation over the past two years, I multiplied $500,000 by 103%, which assumed a 3% annual appreciation rate.  To get the second year's value, after more appreciation, I multiplied the result by 103% again, producing a value after two years of $530,450.

Then I pulled a cap rate of 8.5% out of thin air.  Poof.  Remember, I am trying to get my client a commercial loan here, and any commercial broker (a commercial real estate salesman who specializes in selling commercial-investment real estate) will tell you that my cap rate assumption was probably about right.  I might have used 5.5% for a nice apartment building and 6.5% to 7.5% for a retail or industrial property.

You are reminded that a cap rate is just the return on his money that an investor would earn if he paid all cash for the property, assuming you built in a replacement reserve of around 3% of the Effective Gross Income.  The Effective Gross Income is the number you get after taking off 5% for vacancy and collection loss.


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Now please remember where we are going.  We are trying a create a believable pro forma operating statement on an owner-occupied vet clinic, when rental comp's cannot be found.  You could look for a week and not find another vet clinic within 50 miles that was simply rented from some passive investor.  

You will recall that a pro forma operating statement is just an operating budget for the upcoming year, assuming you built in a replacement reserve to eventually replace the roof and the HVAC unit.

Quick Joke:

My wife and I had just finished a meal at one of our local restaurants when I realized I'd left my wallet at home. As the wife headed to the door to retrieve her purse from the car, she told the waitress what had happened, adding, "But don't worry, I'm leaving my husband for collateral." The waitress took one look at me and asked her, "What else you got?"


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Back to the Lesson:

Even though we have absolutely no rental rate comparable's, we can now compute the net operating income ("NOI") on the vet clinic.  We simply multiply the value of the building ($530,450) times the cap rate (8.5%) to arrive at the NOI ($45,088).


 To value any commercial-investment
property using the income approach, we
simply divide the NOI by the cap rate.  

For example, if an apartment building had a net operating income of $300,000; and we knew that apartment buildings in the area were selling at 5.5% cap rates, we would simply divide $300,000 by 5.5% to arrive at a value of the apartment building of $5.45 million.

To value a commercial property -

Value = Net Operating Income / Cap Rate


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Now let's get back to our veterinary clinic.  We are trying to build a pro forma operating statement, while hampered by the fact that we have no rental comp's.  

To get a net operating income, we simply move the formula around -

NOI = Value of the Property x Cap Rate

NOI = $530,450 x 8.5%

NOI = $45,088

We're getting there!  But your commercial lender will want to see a Gross Income, a 5% Reserve for Vacancy and Collection Loss, some expenses, including a management fee, and a 3% Reserve for Replacement.


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The expenses are easy.  We just assume that the property is leased on a triple net basis ("NNN")!  The tenant (our vet) pays the taxes, the insurance, the repairs, the utilities, etc.   Poof.  Suddenly we have no expenses to worry about.  Am I good or what?  Haha!

But your commercial lender will still want to see you taking off 5% for Vacancy & Collection Loss.  He will want to see you taking off 3% for Management and another 3% for Reserves for Replacement.

We know that the NOI is just 94% of the Effective Gross Income, after taking off 3% for Management and 3% for Reserves.  Therefore to get the Effective Gross Income, we simply divide the NOI by 94%.


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To get the Gross Income, we start by knowing that the Effective Gross Income is 95% of the Gross Income, because we have to take off 5% for Vacancy and Collection Loss.  Therefore we simply divide the Effective Gross Income by 95%.  Voila!  We've done it.



Gross Income:                                         $50,364
Less 5% Reserve for Vacancy:                $ 2,398
Effective Gross Income:                          $47,966

Less 3% For Management:                     $ 1,439
Less 3% Replacement Reserves:           $ 1,439

Net Operating Income:                            $45,088

Take pride in your understanding of today's lesson.


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Did I lose you?  Remember, I had to create a pro forma operating statement, so the lender could compute the debt service coverage ratio on your commercial loan request.  

The problem was that there were only about twenty veterinary clinics within 50 miles of the subject property, and all of them were owner-occupied.  There were no rental comparable's, so I couldn't just say, "Steve's Vet Clinic is leased for $3.00 sf, so the market rent of the the subject property must be $3.00 sf as well."

By assuming a reasonable and believable cap rate, we were able to work backwards to create a reasonable pro forma operating statement.

By the way, this commercial loan successfully (and easily) closed with a credit union, despite the recent bankruptcy.  Hoorah!


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Topics: Cap Rates, commercial loans

Commercial Loans, Cap Rates and Ghetto Properties

Posted by George Blackburne on Mon, Apr 20, 2015

Ghetto2The other day I received an email flyer from a commercial broker trying to sell an apartment building.  The commercial broker boasted that this potential investment offered a whopping cap rate of 14%.  The first thought that passed through my head was that this property was almost certainly in a war zone.

It's very hard for commercial mortgage brokers to close commercial real estate loans in war zones.  Few commercial lenders want to make commercial real estate loans in high-crime-rate, high-drug-use neighborhoods, if for no other reason than the justifiable fear that a vacant, foreclosed commercial property may be quickly vandalized and stripped of its copper.  (Been there, suffered this far too often.)  Therefore the wise commercial loan broker will be sensitive to any clues that might tip him off that he is unlikely to get paid for his hard work on a deal.

You will recall that a cap rate is simply the return on his money that an investor would earn if he paid all cash for an income property.   It's the Net Operating Income (NOI) from a rental property divided by its Purchase Price (times 100% to express the decimal as a percentage).

For example, suppose a five-plex generates $37,432 in annual Net Operating Income.  An investor pays $730,000 for this five-plex.  To compute the cap rate, simply divide $37,432 by $730,000.  The result is 0.051.  If you multiply this decimal by 100%, you get an answer that is easy to understand - 5.1%.  In plain English, the investor will earn an annual 5.1% return on his money.

Okay, if you were an investor, and all the properties were roughly similar, would you rather earn 5.1% on your money or 14.0%?  Uh... is this a trick question?  Obviously, if all else is equal, investors would greatly prefer to earn the higher return on their money.


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But what if you personally had to collect the rent every month, and people were being shot down on a regular basis in that neighborhood?  "Oh.  In that case, I'll take the 5.1% return rather than the more dangerous 14.0% return.  The extra 9% return may not be worth dying for."


True Story:  Thirty years ago I am doing a site inspection on an apartment building in San Jose.  I stepped back to capture more of the building in my camera.  As I did, my foot slipped in a mud puddle... except it wasn't mud.  It was a pool of congealed blood from a fatal knife fight the night before!  The victim's bloody handprints were even visible on a nearby car, as he slid to his death.  Eeuuuu!


Therefore, when I saw the 14% cap rate on that apartment building being marketed, my first thought was, "I'll bet this is a high-crime-rate, high-drug-use area."




Here's another concept I learned only this year.  Just like poor-credit car buyers often have to pay much more for cars than good-credit car buyers, apartment renters in the ghetto often pay more per square foot in rent than far more affluent folks in middle class areas.  Here's why:

Renting an apartment on the safer, more affluent side of the tracks requires a steady job and good credit.  A great many ghetto residents lack a steady job and good credit, so they don't qualify.  They therefore have to  live in an apartment where poor credit will be accepted.  It is ironic, but often apartments in the poorer areas of town will rent for more money per square foot than those in the rich areas.

In defense of the landlords, collection losses from poor-credit renters are often very, very high - as much as 30% to 40% of the scheduled rent.  New tenants may pay their rent for a few months, but then they often stop paying.  These poor-quality tenants next live in the apartments rent-free for 90 to 120 days, as the eviction process slowly inches its way through the courts.  When they finally leave, they often cause far more property damage than the size of their meager security deposits.

The landlords therefore have little choice but to charge poor-credit renters a sizable rent premium.  A 2-bedroom, 1 bath apartment might rent for $800 per month in a safe, middle-class area.  The same-sized apartment might rent for $975 per month in the ghetto.

Therefore, whenever you are working on a commercial loan, be very careful of properties that sell for high cap rates or which have impressive-looking debt service coverage ratios.  These properties may be located in neighborhoods where the landlords are charging a big rent premium.  Such properties may have impressive rent rolls, but the landlords seldom collect more than 60% to 70% of their scheduled rent.

If you're the typical commercial loan broker, you work 100% on commission.  Right or wrong, commercial lenders will look for any legal excuse not to lend in high-crime-rate, high-drug-use neighborhoods.  When you get a commercial loan on a property selling at a very high cap rate or which cash flows unusually well, you are on notice.  This commercial property is probably in a high-crime-rate, high-drug-use area.  This commercial loan will be hard to place.


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Topics: Cap Rates

Commercial Financing, Cap Rates, and Valuations

Posted by George Blackburne on Sat, Nov 22, 2014

Cap_rate_2Today I am going to share with you an easy way to quickly estimate the value of a commercial property.  It's going to involve a tiny bit of math, but please don't freak out or tune out.  You remember how to divide, right?  Fourth grade math?  You can handle it.  And being able to quickly value commercial property is essential to both commercial brokerage and commercial mortgage banking.

In my prior blog articles about commercial financing, I described a Cap Rate as the return on your money that you would enjoy if you bought a commercial property for all cash.  In other words, what "interest rate" would you earn on your money if you bought an office building or strip center for all cash; i.e., you whipped out hundreds of thousands of dollars from your hidden stash under the floorboards, and you eschewed using any mortgage.  By the way, eschew is just a fancy verb that means to "deliberately avoid using or abstain from."

The formula to compute a Cap Rate is Net Operating Income / Purchase Price = Cap Rate.  If you do the caculation shown in the image above, you actually get 0.0711.  You have to multiply the answer by 100% to get a Cap Rate properly expressed as a percentage.

The following funny pic is a tiny bit naughty.  Read on at your own risk.  :-)



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That's enough of a review of Cap Rates.  Remember, the object of todays' training article is to teach you how to quickly value commercial property.

Let's suppose that you are thinking about buying or financing a commercial property, and you want to know what the property is probably worth.   You ask the selling commercial broker for a marketing flier, which usually contains a Pro Forma Operating Statement and the property's net operating income (NOI).

You next make some calls to some local commercial brokers (commercial realtors), and you ask them, "I have a 25-year-old office building in the Kings Town district of Valencia.  What's your best guess at a reasonable cap rate?"  The commercial broker might come back and say, "Depending on the strength of the tenants and the length of the leases, you're probably looking at a cap rate of between 7.25% and 7.75%."  For a quick, desktop valuation, you decide to use a cap rate of 7.5%.

So you now know the property's net operating income (NOI) and the cap rate at which similar buildings are selling.  You can now roughly value the building.  The formula is shown below:


Let's use a NOI on the building we want to value of $237,000 (remember, we got this off the marketng flier) and a 7.5% suitable cap rate (this is the cap rate that the local commercial brokers told us to use).  Plugging and chugging, we have:

$237,000 / 7.5% = $3,160,000

So this commercial building is worth around $3.16 million.

Okay, let's do one more example.  The commercial mortgage borrower submits a commercial financing package that contains a Pro Forma Operating Statement.  You pluck off a NOI  of $657,000.  Local commercial brokers suggest a cap rate of 6.75%.  Now we plug and chug:

$657,000 / 6.75% = $9,733,000

Remember, we started off today to learn a quick and easy way to value commercial buildings.  This was it.


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Topics: Cap Rates

Cap Rates and Commercial Loans II

Posted by George Blackburne on Mon, Sep 23, 2013

This is my second article for commercial loan brokers and commercial investors about cap rates.  In my last article we described how a Cap Rate is simply the return (think of it like "interest") that an investor would earn if he bought a commercial property for all cash.

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Algebraically, the Cap Rate is the property's Net Operating Income (NOI) divided by the Purchase Price, multiplied by 100%.  Let's use a simple example to solidify this ratio in your mind.   Let's suppose an investor bought a small, average-quality, office building with a NOI of $50,000, and he paid $700,000 for the property.  Fifty thousand dollars divided by $700,000 is 0.071.  (Remember that Cap Rates are computed without regard to any commercial loan placed on the property.)


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Multiplied by 100%, we have a Cap Rate of 7.1%.  Cap Rates are commonly expressed as percentages, to one digit.  Therefore Cap Rates look like this:  8.2% or 5.6% or 11.8%.

cap rateNot every investor will be satisfied with the same Cap Rate.  Let's go back to the above example, and now let's assume that a wealthy business owner is leasing one of the six office suites in the building.  In addition to partially-occupying the building, this wealthy business owner lives just five minutes away.  He likes the short commute, and he fears that he might someday be forced to move.  When he hears that the office building has been listed for sale and that an offer to buy the property has already been made, the wealthy business owner submits a competing offer for $740,000.

Just for practice, let's compute the wealthy business owner's new Cap Rate.  Fifty thousand dollars in Net Operating Income divided by the higher, $740,000 purchase price gives us 0.67.  Multiplied by 100% gives us a 6.7% Cap Rate.  Obviously the second guy's Cap Rate is lower because he paid $40,000 more for the same $50,000 worth of Net Operating Income.

So what are some common Cap Rates on average-quality buildings in middle-income areas?


6.0% to 8.0%


7.5% to 9.5%


7.5% to 9.5%


8.25% to 10.25%


9.5% to 11.5%

Here are some general rules about Cap Rates:

  1. The nicer the area, the lower the Cap Rate.  Average-quality buildings in the wealthiest part of town commonly sell at Cap Rates of 6.5% or lower.
  2. The more reliable the income stream, the lower the Cap Rate.  For example, an office building with a 20-year lease from Apple Computer might sell at just a 4.5% Cap Rate.
  3. The more vacant land surrounding or close to the property, the higher the Cap Rate.  The reason why is because if rents ever increase too high, some developer will quickly throw up a competing building.
  4. Buildings in successful downtown areas sell for absurdly low Cap Rates - sometimes as low as 3.5%.
  5. The younger the building, the lower the Cap Rate.

We can therefore tell a lot about a building, just by its cap rate.  For example, if you tell me that I can buy an apartment building at a 14% Cap Rate, I would pretty much bet that the area suffers from pervasive drug use, a high crime rate, and gang violence.

If you tell me that an industrial building just sold for a 7.0% Cap Rate, I would bet that the property is less than seven years old, has tall ceilings (important to a modern warehouser, who stack pallets very high), and a stronger-than-average tenant.

If you tell me that an office building just sold at a 5.0% Cap Rate, my bet is that the office building is located in an upper-income downtown area with virtually no vacant land within a mile (prevents competing buildings from being built).

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Topics: Cap Rates