Valuation of commercial real estate
The valuation of commercial real estate depends on multiple factors that are intrinsic to the property and are processed through metrics that could use the comparable sales, cost or income capitalization approach to determine its value. Historically, the income approach has been considered the most effective method of obtaining the value of income-producing real estate, especially from an investor’s perspective. Even the old adage that the three most important aspects of real estate are “location, location, location” also depends on the income that has been or potentially can be generated on the site. The location’s proximity to vital infrastructure, the central business district, schools, major roads, etc. it will affect your suitability, the quality of the tenure and the market rents that can be dictated or expected. However, the structural integrity and functionality of the property for its intended use, e.g. multi-family, office building, industrial, retail, or mixed use to name a few, play an essential role in its ability to be a generation tool. from income.
Motivation to enter the commercial real estate market as an investor is often driven by cash flow; This differentiates the impetus of owning an owner-occupied commercial property as a place to conduct primary business or to buy a home that represents a family abode, a pride of ownership, and a place to create memories for the future. The complexity, risk and illiquidity of capital during the acquisition and management stages of the property that only becomes liquid at disposal or cash out – refinancing guarantees a premium to compensate the investor for taking the risk with their capital in the arduous structuring conditions the most effective use of capital / debt in the capital budget in relation to the unpredictability of the market and the instability of the local market. To achieve this goal, a discount cash flow analysis may be prudent in determining the most effective allocation of capital in a deal or whether the deal is worth consummating based on due diligence findings. Basically, the investor is buying an income stream; Commercial real estate as an asset class has the additional benefits of asset appreciation (generally), debt reduction from income generated to pay off debt (mortgage), and tax write-offs, including depreciation expenses, which reduces taxable income and increases cash flow. A Pro Forma is generally prepared for the projected holding period that reflects the expected income and expenses under the current property if it is a refinance or a new property if it is an acquisition. The investor then determines what discount rate they believe is acceptable to justify and compensate for the risk of capital immobilization according to the risk of the project, the risk premium, the cost of debt and the local and general economy.
Discounted cash flow analysis used in commercial real estate is synonymous with capital budgeting discounted cash flow methods. The net present value (NPV) and the internal rate of return (IRR) are used to determine the viability of a project. The NPV method discounts the future cash inflow to the investor’s cost of capital to determine the present value of the investment. This is then compared to the current cost of making the investment. The Internal Rate of Return (IRR) determines the return that equals the present value of the cash inflows and cash outflows of the investment. This return is then compared to the cost of capital required to make the investment. An alternative method of determining the value that is used in the income approach to valuation is to use the current net operating income (NOI) of a project or the net operating income expected by investors under the new management and divide this number by a capitalization rate (capitalization rate) that includes a safe rate of return, for example, a five-year U.S. Treasury note plus a risk premium for the project, etc., a cap rate to justify the investment and provide a property valuation.
Value = net operating income / capitalization rate
The net present value method has been referred to in the previous two paragraphs under the general description and implementation of the Discounted Cash Flow Analysis. The internal rate of return is another method used by many investors to help decide whether a real estate project is worth undertaking. The goal is to calculate an overall return on investment (ROI). This is accomplished by using the property’s current operations and projecting its future returns. This rate calculates the dollar invested, when invested, and gives a return based on when the cash flows are received and the anticipated income from the resale cash flow. This yardstick can also calculate after-tax return. This return can be used to compare various investment opportunities. However, this method uses assumptions and is only as good as the “garbage in, garbage out” assumptions used. Therefore, the astute investor must project multiple possible outcomes, including high, moderate, and low returns, synonymous with the best, most likely, and worst-case scenarios.
The confidence and preference of individual investors and business entities of specific valuation models and methodologies can sometimes be traced to experience, industry standards, and what is compatible with the investment objective. Many times several methods are used, for example, net present value and internal rate of return are used to analyze the financial viability of a real estate business to see if it meets the applicable investment standards determined by investment managers. However, most practitioners rely more on a specific method and use others as secondary instruments that support or do not support the primary method. In the event that the investment reaches or exceeds the desired return through multiple methods, if all other facets of the deal are supported by due diligence, it will be sought and consummated if there is a match of minds between buyer and seller. .