RES 110 Session Five Commercial Real Estate Math Concepts Commercial Real Estate Math Conceptsand Understanding the Value of Commercial Investment Property Understanding the Value of Commercial Investment Property

Commercial Property is Income Property Dealing with that income stream is predicate on the concepts of the “Time Value of Money “.

Time Value of Money Time value of money quantifies the value of a dollar through time… Future Value through compounding Compounding is when interest (or net cash flow) earned is reinvested to earn more income, e.g. interest on interest Present Value through discounting Discounting is when future income amounts are recuced in value because of the application of alternative opportunity returns available, risk and inflation, e.g. future dollars reduced to present value

Time Value of Money (cont.) Commercial real estate investment frequently considers the future value (FV) of the income stream provided by a particular property. The compounding rate considers the property return reinvested at a rate satisfactory to the investor. FV is not generally used as a value indicator as it typically represents only a subjective goal of an individual investor. We will not, therefore, further deal with FV in this course.

Time Value of Money (cont.) Commercial real estate valuation for a particular property applies the “discount rate” which is the percentage rate that future dollars are discounted to present value, For example Inflation……………….…2% Risk Free Rate……..….2% Risk Factor………….….3% 7% Discount Rate = 7%

Time Value of Money (cont.) ALTERNATIVELY – A SHORT CUT TO THE DISCLUNT RATE CHOICE: Combine the rate for inflation with the safe rate by using the 10 year US Treasury bill rate. For example: 10 year T Bill rat: (historical) as - Risk Free Rate ……. 3% Risk Factor ……… 4$ Discount Rate ……7%

Commercial Real Estate Math Involves Lender Ratios 1.Loan to value ratio (LTV) 2. Debt service coverage ratio 3. Loan per square foot ratio (net retable/gross floor area)

Establishing Value for Commercial Property

Key Investment Terms Rate of Return -CAP Rate,Internal Rate of Return (IRR), Financial Management Rate of Return (FMRR) Initial Investment Equity Leverage Cash Flow Before Debt Service (CFBDS) Cash Flow Before Taxes (CFBT) Cash on Cash Return

Some Investment Strategies Income Stability Upside Potential Property Type Diversification Use/Investment

Market Conditions Affecting Value/Price Supply and Demand – Properties and Tenants. Location Available Financing

Determining Value: Rules of Thumb* Cash on Cash Return Cash on Cash Return Capitalization Rate ie. The desired, offered or market indicated “free and clear” rate of return. Capitalization Rate ie. The desired, offered or market indicated “free and clear” rate of return. Gross Rent Multiplier (GRM) Gross Rent Multiplier (GRM) * Used by buyers, sellers, brokers, researchers, consultants, appraisers etc..

Steps in Commercial Property Value Determination 1.Determine rent roll and potential rental income. 2.Dedudct vacancy and collection losses. 3.Determine operating expense. 4.Calculate net operating income (NOI)

Net Operating Income Potential Rental Income +Other Income (affected by vacancy) -Vacancy and Credit Losses =Effective Rental Income +Other Income (not affected by vacancy) Gross Operating Income -Operating Expenses = Net Operating Income (NOI)

Importance of the Net Operating Income Calculation From Session 4, remember why NOI is typically used to show economic viability of a property. It is independent of financingIt is independent of financing It is independent of income taxesIt is independent of income taxes

Capitalizing Income Accurately define Net Operating Income (NOI) and define the NOI as “stabilized”. Research or build the capitalization rate (short cut) considering: 1.Safe rate ( typically 10 year U.S Treasury Bill that includes inflation rate) 2.Risk rate (based on property characteristics and income stability) = CAP rate ( same as “Discount”)

Application of CAP Rate Formula - IRV Income (NOI) divided by Cap Rate (desired return) equals Value (investment va;ue/price)

The Famous IRV

Capitalizing Income (cont.) So where do the little CAP rates come from? Well my dears From market data e.g. a brokers sale listing that shows financial data (Westlake Associates) or a CRRE quarterly report that says that “Class A office buildings in downtown Seattle sold last year at an average CAP rate of 4.2%.” OR Do it yourself by building the CAP rate as shown two sides previously. This is also a good idea to compare your own judge ment to that of the market. The following slides will give you some feeling for the process.

Two Investment Buildings Building A Building B $ 50,000 NOI$ 50,000 NOI

Two Investment Buildings (cont.) Building A Building B $ 50,000 NOI $ 50,000NOI Tenant: Tiffany &Co Tenant: Ajax Tattoo Folks Inc. Location: 5 th Ave, NYC Location: Aurora Blvd, Seattle

Two Investment Buildings (cont.) Building ABuilding B $ 50,000 NOI $ 50,000NOI Tenant: Tiffany &Co Tenant: Ajax Tattoo Folks Inc. Location: 5 th Ave, NYC Location: Aurora Blvd, Seattle CAP ( Rate Calculation: CAP Rate Calculation: Safe Rate: 3% Safe Rate: 3% Risk Rate: 2% Risk Rate: 7% =CAP Rate 5% = CAP Rate 10% Safe Rate: 2% Risk Rate: 3% CAP Rate 5%

Tiffany Bldg. (A} Ajax Tattoo Bldg (B) Cap Rate: 5% Cap Rate 10% Now lets IRV it--- $ 50,000 (I)$ 50,000 (I) divided by.o5 (R) divided by.1o (R) = $ 1, 000,000 (V) = $ 5000,000 (V)

Capitalizing Income (cont.) The higher the Cap Rate (and risk)The higher the Cap Rate (and risk) the lower the value the lower the value The lower the Cap Rate (and risk)The lower the Cap Rate (and risk) the higher the value the higher the value Generally cap the next year’s NOIGenerally cap the next year’s NOI

Leveraged Investment Cash on Cash Return CFBT = NOI – Annual Debt Service Cash on Cash = CFBT ÷ Initial Investment

Internal Rate of Return ( IRR ) Investment (negative number) Sell 0 10 years of cash flow + sale proceeds Sale proceeds or “Terminal Value” based on Exit or Terminal CAP rate 65

Financial Management Rate of Return A term frequently used to describe the rate of return accomplished or projected after applying debt service and income tax considerations to the NOI calculation. Unlike the NOI capitalization method, it includes the subjective elements of a particular income tax rate, depreciation calculation and debt service obligation ) of the investor. An important analytical tool for the investor. 

The Appraisal Approach to Valuation of Income Property

Some Appraisal Purposes Setting or rationalizing a sales price Estimating insurance coverage requirements Calculating loan to value ratios. Valuing a partnership interest Condemnation proceedings Other

Approaches to Value Market Data Approach to Value The Cost Approach to Value The Income Approach to Value

Some Principles in Establishing Appraised Value Substitution- The availability and value of alternatives. Highest and Best Use - The use of a property that will create the highest financial return on the investment Anticipation - Future trend/value issues.

The Reconciliation Process in the Appraisal Consolidate Information and Analysis Review/Weight Approaches to Value