How to Calculate Commercial Real Estate Value
How to Calculate Commercial Real Estate Value (My Cap Rate Trick)
Commercial real estate is a valuable asset, and it’s important to understand how to calculate its value. In this 7 minute video, I explain the cap rate and show you how to use it to determine the value of a commercial property.
Transcript:
Hey, Jeremy Cyrier here from MANSARD. I get this question all the time; what’s a good cap rate? Well, it’s kind of a complicated question, because most people want to know what a good cap rate is because they want to benchmark against what someone else paid using the cap rate. I don’t like using that approach at all. Comparable cap rates are helpful, but I actually like to build my own cap rate. So one of the things I’m going to show you today in this video is a tool that we use to develop a valuation using a cap rate that’s based off of some assumptions. These assumptions are going to come from the debt market, your cash on cash return, and then what the NOI of the property is. So let’s go take a look.
How Investors Value Commercial Property
So what we do is we take the gross operating income for a property, and let’s say that your property does $750,000 a year in revenue and it costs you, say, 200,000 bucks a year to operate it. That would give you an NOI, or net operating income, of $550,000. That’s a pretty quick way to get to that number, what the NOI is. And most of the time you’ll stop here and just put a cap rate on it. You’ll say, “Ah, what are cap rates in the market?” Take the 550, multiply or divide it by 10, or 10%, or 7%, or 6%, whatever the cap rate might be that you think is the right cap rate for this property to come up with the commercial real estate value. Don’t stop here. That’s why we built the tool, because we want to get a little more accuracy for what we think the cap rate might be. And a shout-out to Mike LipseyExternal link. for turning me onto this tool, and I kind of developed my own version of it.
How Interest Rates Affect Cap Rates
So here we’ve got the amortization period. So typically you’re going to go to a lender and you’re going to see anywhere from a 15, 20, 25, maybe even 30 year amortization period. For this example, I’ll put 25 years in, and I’m going to carry an interest rate of 5.25%. Now, interest rates go up and down. You might see them at a low point at three, three and a half percent. They could go up as high as five and a half, six, six and a quarter. So I’m just going to use five and a quarter as an example, in this case. Now, the next thing we’re going to do is figure out what our loan to value is. Those can vary as well. You might see a loan to value anywhere from geez, 80% down to 10, 20, 30%.
Cash on Cash Returns and Commercial Real Estate Valuation
In this case, we’re going to use a 70% loan to value. And you’ll see now that we’re starting to get some outputs. Now, the output here is partial, because we haven’t put in our cash on cash return. We have 30% of the purchase going in as equity out of our investor’s pocket and the investor’s going to want a cash on cash return. So if we make an assumption of what that cash on cash return should be, we’re going to then get a cap rate that would support that. So let’s say that the investor’s looking for a 10% cash on cash return. We now have an 8.03% cap rate. That cap rate is made up of 70% debt and 30% equity. That’s how pretty much every piece of commercial real estate is bought, unless it’s a cash deal and you’re not going to a lender. You’re going to just go ahead and borrow some funds and use debt and equity to purchase. What this tool allows you to do then is to say, okay, at $6.8 million at an 8.03 cap, assuming the net operating income is $550,000, I can get a 10% cash on cash return at that cap rate.
Now what happens if I lower my cash on cash return requirement? And let’s say, I have to get 8.25%. What’s going to happen? Well, my cap rate goes down to 7.51% because I’m now adjusting the cost of equity that your cash on cash return over my cost of debt, which is still 5.25. And you’ll see as that cap rate comes down, that valuation goes up. So let’s say that you go back to the bank, you call them up and you say, “Hey, what are prevailing rates like right now?” And the bank says, “Well, we could finance this deal at 5.85%. And in fact, we’re going to be comfortable at a 65% loan to value.” That would then tell you that to get an 8% cash on cash return, the right cap rate for this property is 7.84%, which gives you an estimated value of seven million dollars. Okay?
So as we move these assumptions around, you’ll see the cap rate’s going to adjust. This is called the band of investment theory. And it’s a very helpful way to get a cap rate that it factors in the cost of financing and the cost of equity to come up with what could function in the market. What’s can be financed in the market? What could be attractive in the market?
So I hope you like this video. This is a really helpful tool. I built it myself in Excel. It’s quick and easy, and it gives you a super, super nice, smooth, clean way to get to that commercial real estate value and a cap rate that’s just right for what you’re trying to accomplish. If you like the video, hit like, appreciate it, and subscribe to our channel. And see you in the next one. Thanks.
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Schedule a free consultation with our team of experts to learn more. We’ll discuss real-time commercial real estate market opportunities and help you determine the best investment strategy for your portfolio.
