This is the final installment on the 3 part series discussing the different terms that relate to commercial real estate. In this post I want to discuss how to put all of the terms that we learned in the previous two posts together, in order to analyze properties and quickly determine whether or not they are suitable for your investment goals.
If you have not already done so, please read the first two posts in this series so you can have a better understanding of the concepts in this post.
Assuming you have read the previous articles in this series, you should now have a better understanding for Gross Income and how to account for vacancies and bad debt in order to get your Effective Gross Income (EGI). You should also have a better understanding for Operating Expenses, Net Operating Income, and Debt Service.
Now you need to put all of those terms together in order to properly analyze a property.
1.) Cash Flow
As it relates to real estate investing, cash flow is the amount of cash that a property is generating after all of the expenses and debt service is paid. This number should ALWAYS be positive. If this number is negative, then that means that the property is operating at a loss and will be taking money out of your pocket on a monthly basis. For Example:
Effective Gross Income (EGI): $100,000
(minus) Operating Expenses: $45,000
(equals) Net Operating Income (NOI): $55,000
(minus) Debt Service: $35,000
(equals) Cash Flow: $20,000
2.) Cash-on-Cash Return
Your cash-on-cash return is a ration that allows you to see what your annual return would be on your cash invested for the down payment. For example, let’s say you purchased a commercial property for $1,000,000 with a 20% down payment of $200,000. From the example above, the property is generating $20,000 a year in positive cash flow. Based upon these numbers, your cash-on-cash return would be 10%. See Below:
Cash Flow: $20,000
(divided by) Down Payment: $200,000
(equals) Cash-on-Cash Return: .10 or 10%
Now this example gave you the cash on cash return based off of your down payment, however, if you wanted to be more accurate with your return, you would include your total acquisitions costs and not just your down payment. So you would take the cash flow and divide it by your total acquisition costs which would include down payment, closing costs, soft costs, etc. This number is very important to investors because it symbolizes how long it will take for investors to recoup their principal investment. Depending on your market and the needs of your investors, you will probably want to acquire properties that generate at least a 12% cash-on-cash return for you and your investors. This will allow your investors to get a good upfront return on their capital and still have the potential for greater returns if the property sells at a profit at a later point in time.
3.) Capitalization Rate (Cap Rate)
The capitalization rate is the rate of return that a property would generate if it was purchased with all cash and not financed. So, if you were to pay $1,000,000 cash for a building and it generated $100,000 in net income, your “cap rate” would be 10%. See Below:
Net Operating Income (NOI): $100,000
(divided by) Purchase Price or Value: $1,000,000
(equals) Capitalization Rate: .1 OR 10%
Capitalization rates are used to value commercial properties in relation to other comparable properties (“Comps”) in the area. As a simple reference point, you want to purchase properties at a higher cap rate than the comps in the area and sell at a lower cap rate than when you made the purchase. The reason for this, is because the lower the cap rate, the more the property will be worth. For example using the information above, you purchase a building at a 10% cap rate and made some repairs and upgraded the quality of tenants and the quality of the building. Let’s say that buildings in the area that are similar to your newly renovated building are selling at a 8% cap rate. To make the example simple, we will assume that there has been no increase in your Net Operating Income. At an 8% cap rate, your building would be worth $1,250,000. Below is how we came up with that value.
Net Operating Income (NOI): $100,000
(divided by) Capitalization Rate: .08 OR 8%
(equals) Value: $1,250,000
Now I kept these numbers simple for illustration. In reality if you made renovations to a property and increased the quality of tenant and quality of building, your net operating income would increase as well, which would make the building worth more than $1,250,000. When you are doing your due diligence on commercial properties, you always want to know the “cap rate” that comparable properties are selling at, so you can attempt to acquire a building at a higher “cap rate” than the current market. This will give you the opportunity to renovate and reposition the property so that you can increase the equity in the property, similar to the way residential real estate investors purchase properties below the market comps so they can fix them up and have additional equity built into the property.
By combining all of the terms and formulas from the three posts in this series, you will have a good foundation to analyze a variety of commercial properties in your marketplace.
If you have any questions, we can carry the conversation over into the comments below so please let me know your thoughts and comment below.