Analyzing commercial real estate is not nearly as complicated as it may at first appear. In fact, once you have the basic information about the property, analyzing the deal can be done quickly and easily if you understand the 5 basic terms.
- Income and Expenses: The income is all the money produced from the property (rents, etc) and the expenses are all the costs involved with owning and maintaining the property excluding the mortgage payment.
- Net Operating Income (NOI): This is how much money the property brings in before paying the mortgage, or income minus expenses.
- Cash Flow: This is actual profit you make, or the NOI minus the mortgage.
- Cash on Cash Return: This describes how fast you get your down payment money returned to you, or Cash Flow divided by your down payment.
- Capitalization Rate (CAP Rate): This is a simple metric used in commercial real estate that compares the sales price to the NOI.
In the following video, you’ll learn all about these 5 key terms as well as an example of a deal with real numbers. Here’s analyzing commercial real estate quickly and easily:
Analyzing Commercial Real Estate Quickly and Easily
Commercial real estate is not as complicated as you think it is
3 Things You Want to Know About the Commercial Real Estate Deal You are Analyzing
- How much money does it make
- What is your return on investment
- How does this investment compare to other investments
5 Key Investment Terms for Commercial Real Estate
Income and expenses
- Every commercial property has both
- Income can be rents collected, lease payments, laundry income, and even late fees
- Expenses are insurance, taxes, utilities, repairs, landscaping, and property management fees
- One thing that is not included in expenses is the Mortgage payment
- It is a debt expense
Net Operating Income (NOI)
- Definition: Your income minus expenses
- One of the most important terms of these five
- As your net operating income go up your cash flow and the value of the property go up
- When it goes down so does the cash flow and property value
- Definition: Your NOI minus your mortgage payment
- How fast is your money moving
- If you get your money back in 1 year it is 100% cash-on-cash return
- If you get your money back in 2 years it is 50% cash-on-cash return
- “Cap Rate” is NOI divided by the sales price
- If you pay all cash for your investment what would be the return on that investment
- 500,000 property bought outright now mortgage, what is the return on that property?
- High cap rate property will be in a low to moderate income neighborhood
- The higher you go the higher the risk the higher the potential return but the price is lower
- Low cap rate is in a wealthier neighborhood
- Lower cap rate is a lower risk, but also lower return and higher sales price.
Rules of Engagement for These Five Key Terms (10:06)
- Do not make an offer until you calculate each of these terms
- For income and expenses you need the income to be greater than the expenses
- The NOI needs to be greater than the mortgage payments
- Cash Flow needs to be positive
- Cash-on-cash return must be greater then or equal to 10%
- Cap rate should be greater than or equal to 8%
3 Assumptions for This Example:
- The property purchase price is $450,000
- Down payment is 10% so $112,500
- Mortgage Payments are 20,000 per a year
- On this property the income is 48,000 a year
- Expenses are 12,000 a year
- This means that the NOI is 48,000 – 12,000= 36,000
- Cash flow is 36,000(NOI) – 20,000 (Mortgage) = 16,000
- Cash-on-cash return is 16,000 (cash flow) divided by 112,500 (down payment) = 14%
- Cap rate is 36,000 (NOI) divided by 450,000 (sales price) = 8%
Amidst the outbreak of coronavirus, commercial brokerages and investors are staring at some very, very murky waters.
Much of the nation is stuck working at home, in-person meetings are gone, and property owners are reluctant to make any immediate business decisions.
With such great levels of unknown, new deals and opportunities are flat out difficult to spot, and even more difficult to close.
What they’re left with is new downtime and a lot of unanswered questions.
This is why we believe that right now is to hone your commercial real estate analysis processes. You can use the additional downtime you might otherwise spend calling owners to conduct more thorough, nuanced, analysis and gather the data needed to make decisions in a highly questionable market.
Below, we’ll look at the different areas of commercial real estate analysis, including the metrics you need to be looking at right now and the resources needed to do so during quarantine.
Commercial Real Estate Analysis in 2020
There are multiple forms of commercial real estate analyses (which we’ll get into below), but suffice it to say each type of analysis can be used by different parties for different purposes.
Real estate investors, property managers, lenders, brokers, and various contractors all analyze real estate in their own way. What it comes down to, is what part of a property or market they need to understand to inform their business.
Types of Commercial Real Estate Analysis
There isn’t just one, single way to conduct commercial real estate analysis. In fact, there’s a multitude….
Commercial property analysis is often the first step an investor takes before deciding whether to move forward with the purchase or sale of a property. There are four main components of a commercial property analysis:
Numbers include the potential purchase/sale price, as well as numbers associated with the physical property, including square footage, number of units, NOI and more.
Narratives are the stories that tell the unique history of a property, which may influence how a commercial real estate professional interacts with the property.
Indications are the signals that point to a person’s intentions related to a property.
Assurance is some sort of validation that action is worth taking.
For example, an investor may be looking to purchase a small, garden-style apartment building. As part of his or her due diligence, they run through a commercial real estate checklist intended to help evaluate various investment opportunities.
One of the key steps on this checklist is to run a property title search.
After doing so, the property lien search reveals a mechanic’s lien on the property. The investor digs a bit deeper, and learns that the existing owner owes a roofing contractor $50,000 for services rendered back in 2015. This is part of the property’s narrative. For the investor to take title to the property, this lien will need to be cleared up.
Typically, a property analysis will be used in conjunction with a market analysis, investment analysis and financial analysis to inform an investor whether a deal is worth his while.
An owner analysis is a great tool for industry professionals looking to source new business leads.
This type of commercial real estate analysis typically includes information about the property owner, including their name, address and contact information.
Properties are often held in a limited liability company (LLC) or trust, which makes finding owner information more difficult – but tracking down that information is critical for those in the industry.
In addition to finding contact information for an owner, an owner analysis may also include information about a property owner’s other holdings.
For instance, a debt broker may discover that the owner of one self-storage facility also owns three other self-storage facilities and two parking garages in the same general location. The debt broker may then pitch the owner on refinancing their entire portfolio while interest rates are still low.
Someone’s ability to find commercial real estate investors can really affect their success in the industry. It’s important to build relationships with owners so you’re top-of-mind when they have a need for the type of services you offer.
An investment analysis is a type of commercial real estate analysis that helps to compare one investment against another. It can be very useful in helping someone differentiate among asset classes. A builder, for example, may be trying to decide how to best utilize a vacant parcel located in the heart of downtown Boston.
An investment analysis would include what’s known as a “highest and best use” analysis, which looks at what can physically be built on the site given local regulations and then assigns potential values for each individual scenario.
A 10-story lab building might prove more valuable, from an investment perspective, than a 20-story apartment building – or vice versa. An investment analysis can be used to validate and verify your investment decisions.
A portfolio analysis takes the financial analysis for each property within a portfolio and then evaluates the properties together as a whole.
For instance, a warehouse facility may be a loss-leader in a portfolio, but several fully-occupied apartment buildings may be offsetting those losses when the portfolio is analyzed as a whole.
Running a portfolio analysis, either on your own or through the support of a management company, is essential for investors considering their exit strategies. When used in conjunction with a market analysis, for example, an investor may realize now is a great time to sell an underperforming warehouse facility.
This will allow them to recapitalize and pursue investing in another apartment building, an asset class that is thriving in their portfolio.
Property managers, investors, and sales brokers often analyze the portfolios of others, too. Doing so can provide valuable information about whether an owner should buy or sell (assets and/or services).
A property manager, for example, might discover that Property Owner Sam’s portfolio has a 30% vacancy rate across the board. In turn, the property manager reaches out to Sam and offers to manage his portfolio. He promises to decrease the vacancy rate, which will more than offset the cost of his services.
A commercial real estate financial analysis has many components. Inputs can range from construction costs to management fees. A financial analysis will almost always look at the existing rent roll, vacancies, and other sources of income generated by the property (e.g., parking spaces, storage lockers and coin-op laundry).
The numbers generated though a financial analysis can be used in many ways. If the numbers are particularly strong, an owner may use the analysis to help attract a new investment partner.
Alternatively, you may use the numbers to help attract low-cost debt. On the flip side, running a financial analysis can help illuminate red flags that would help deter someone from purchasing, investing in, or otherwise servicing a specific commercial property.
A commercial real estate market analysis is an essential part of most real estate transactions. It’s a form of due diligence that reveals trends and helps industry professionals forecast into the future.
A market analysis looks at various demographic, economic, and socioeconomic factors within a given industry. It typically includes indicators such as local employment rates, housing vacancy rates, median cost of housing and more.
A market analysis helps to reveal critical information about local supply and demand, market rents, capital market access, and a property’s revenue-generating potential.
For example, the real estate arm of a pension fund may specialize in buying Class A office towers in primary markets. However, a major building boom in one specific market may give them pause.
If an influx of new Class A office product is about to come online in that market, they’ll be facing steeper competition. They might be better off investing in a different market or different asset class for the time being.
Market analyses are also incredibly helpful to residential investors, as they help to identify unique market opportunities. Coming out of the Great Recession, for instance, savvy real estate investors saw an opportunity to pick up low-cost rental units by finding pre-foreclosures.
All they needed to do was look back at recently sold properties to realize that there was a market for these properties, many of which were single family, standalone homes. In several markets, rents remained high.
Those who knew how to find distressed properties were able to purchase properties at a discount and then lease the units back to the owners at a fraction of the cost.
A market analysis can be valuable to lenders and developers, as well.
For instance, a lender would want to see a market analysis to verify whether the rents they can get are in line with market realities.
A commercial real estate developer might use a market analysis when selecting finishes for an apartment building: for instance, can it command high enough rents in the market area to warrant installing floors with radiant heating? Possibly not.
Just as a property analysis looks at an individual property, and a market analysis considers elements of a specific market, an industry analysis looks at features of an industry as a whole.
This could entail looking at how an industry is performing overall (e.g., nationally and even internationally), or how an industry is performing at your local level.
Consider a hotel developer. The hotel developer would want to conduct an industry analysis to understand: total available rooms in the local market, average daily room rates, revenue per available room, average occupancy rate, market penetration and marketing cost per booking.
An industry analysis tells a hotel developer whether a new hotel is really viable in that market, and if so, what scale and type of hotel is most likely to turn a profit.
Similarly, an industry analysis can help real estate professionals identify certain market trends. One of the biggest trends in retail, as of late, is the move from big-box retail to more experiential retail.
A leasing broker may use this information to narrowly target specific retail users, whereas a commercial property owner may decide to reposition the space on his ground floor to accommodate up-and-coming uses.
Monitoring industry trends is no easy task. Most people rely on commercial real estate reports, such as those produced by brokerage companies like Colliers and JLL, to inform their industry analyses.