Know the process for measuring an investment property's potential value

Richard C. Reimer, president, Mortgage Industry Consultants

As published in Scotsman Guide's Commercial Edition, December 2006.

Investors and property-owners must consider the future earnings of a commercial property to determine a project's feasibility. As such, brokers who want to help their clients determine whether a project will be profitable should understand the capitalization ("cap") rate and the internal rate of return (IRR).

Both of these rates help determine a project's potential value. To help your client determine the cap rate and IRR accurately, you must know what factors go into determining these calculations.

Cap rate

The cap rate is usually derived from three sources:

• Market and/or buyer's objectives: When the cap rate is derived from the market, there are a host of market issues affecting it.
Often, the cap rate may be further adjusted because of intuitive decisions made by the buyer, based on factors such as building and construction class, occupancy levels, property age and condition.
• Published data: Some national appraisal and accounting firms do quarterly surveys to determine cap rates in several metropolitan markets.
• Market survey: The commercial divisions of local real estate companies provide this information.

Cap rate is determined by dividing the net operating income (NOI) of the sale comps by the sale price. The cap rate's accuracy depends on the accuracy of the other components in the formula.

Risk is an essential component of the cap-rate formula because the lender's perception of risk has a direct impact on the loan pricing. Risk is determined by two major factors -- market risk and property-specific risk.

With market risk, lenders evaluate the property type, stage in the development cycle and the specific metropolitan area.

With property-specific risk, lenders look at these factors:

• Whether the property is single-purpose or special-purpose
• Lease-rollover rate
• Rent and occupancy levels
• Expenses and capital improvements
• Current cash flow
• Amortization
• Value appreciation and income appreciation

In measuring risk and returns, lenders examine how sensitive a specific property's cash flow is to market-wide fluctuations. They then make a judgment call and price the transaction at a level commensurate with their perceived risk.

Leases

The cap rate's accuracy also depends on the accuracy of the NOI (which is essentially gross operating income minus operating expenses). And because NOI depends on the types of lease used in a property, it is important to understand the types of commercial leases. They are categorized as the following:

• A net lease obligates the tenant to pay utilities, real estate taxes and other special assessments.
• The net-net (NN) lease generally requires the tenant to pay all items included in the net lease plus the insurance premiums agreed upon in the contract.

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