Valuation of Commercial Real Estate: Part 3

There are various ways for income capitalization: gross rent multiplier, capitalization rate, cash-on-cash return and discounted cash flows.

Gross Rent Multiplier

• Price divided by Gross Income
• Least used method – more common with MF
• Advantages
• Very little info required, easy to obtain
• Use for quick comparisons of similar properties
• Disadvantages
• Does not take into account many important factors, including appreciation, operating expenses, leverage, taxes or risk level

Capitalization Rate

• NOI/Purchase Price = Cap Rate
• NOI/Cap Rate = Purchase Price
• Advantages
• Takes into account income/expenses
• Most commonly used method
• Easy comparison
• Disadvantages
• Does not factor appreciation, leverage, taxes, risk
• Only considers 1st year projected income
• Not appropriate in many situations (near-term rollover, heavy capital requirements, low occupancy, value-add situations)

 Cash-on-Cash Return

• COC = cash flow after debt but before taxes initial equity investment
• If paying cash, COC = Cap Rate
• Good way to determine “yield” in early years
• Most comparable to dividend yield rate on a stock or the coupon rate on a bond
• Advantages
• Takes into account capital costs and debt structure
• Easy to understand for cash oriented buyers
• Disadvantages
• Does not account for appreciation/depreciation, taxes or risk level
• Hard to get meaningful comparison among potential investments

Discounted Cash Flows

• Use forecasting model of expected cash flows
• Can determine IRR, NPV and capital accumulation
• Advantages
• Takes into account all facets of an investment, including cash flow, capital repairs, debt and sale
• Recognized as best method for valuation
• Use of Argus Software and other models helps
• Disadvantages
• Can be difficult to get all info – relying on estimates
• Heavily “back-end” weighted due to impact of exit assumptions

Net Present Value (NPV)

• Sum of the present value of all future cash flows minus the initial investment
• Advantages
• Allow investors to set return benchmarks and price accordingly
• Good for comparing alternatives
• Disadvantages
• No compensation for size/time disparities
• No consideration of how intermediate cash flows can be reinvested
• Positive and negative cash flows discounted at same rate

Internal Rate of Return (IRR)

• Percentage rate earned on each dollar invested for each period its invested
• IRR is the rate at which NPV = $0
• Advantages
• Good method for comparing alternatives
• Answers basic questions about expected timing and amount of +/- cash flows
• Disadvantages
• No compensation for size/time disparities
• No consideration of how intermediate cash flows can be reinvested

Click here to see the entire Valuation of Commercial Real Estate.

Contributor: 

 

Aaron Mesmer

Acquisition & Sales

Block Real Estate Services

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