A new year offers a new time to review some of the fundamentals of commercial real estate, starting with the realization commercial transactions differ greatly from residential deals. Many of us have experienced the emotional roller coaster that comes with the purchase or sale of a home. Buying or selling commercial property involves analysis, not emotion.
Success starts with good common sense and financial boundaries. Setting realistic goals and answering some basic questions constitutes the first steps in deciding if a commercial real estate purchase is right for you. How much can you afford to pay? How much do you expect to make on the deal? How many tenants are in place and paying rent? How much rental space remains vacant? Is a multi-tenant property or single-tenant property the best choice? How does the economy play into certain types of investment property? Is there growth in the market?
There are many ways to evaluate a particular property that can help you make an informed investment decision. Two common metrics for evaluating commercial real estate are net operating income and capitalization rate.
The net operating income (NOI) of a commercial real estate property is calculated by taking the property’s first year gross operating income and then subtracting the operating expenses for that year. A property that produced $100,000 in income and $50,000 in operating expense would have an NOI of $50,000.
The capitalization rate is used to calculate the value of income producing properties. It is the ratio of NOI to the property asset value. For instance, a property priced at $500,000 with an NOI of $50,000 would offer a capitalization rate of 10 percent.
Another valuable property valuation tool is the annual property operating data (APOD) report. It shows an income or rental property’s current annual financial performance. There are four components of the investment’s annual property operating data that essentially comprise an APOD: rental income, operating expenses, loan payment and cash flow.
Many commercial real estate investors rely on bank financing to purchase their properties. This is especially true in today’s low interest lending environment. These investors can use the cash-on-cash formula to show the return they can earn on the equity or out-of-pocket portions of their investments. The cash-on-cash formula is a ratio of the annual pre-tax cash flow of the property to the amount of cash the investor puts into the purchase.
I would suggest always doing your homework and hiring professionals when working on your investments, whether that’s the stock market, treasury bonds or commercial real estate.