Cap Rate is the anticipated first year return from the buyer’s perspective on the property. Cap Rate is calculated by dividing net operating income by the projected purchase price. Example, if net income after operating expenses is $100,000 and the purchase price is $1,000,000, then the property is being purchased at a 10% cap rate. Remember that NOI adjusts for just the operating expenses of the property. It does not include capital expenses, reserves, debt service, etc.

It is important to understand that cap rate is just a preliminary decision analysis and there are flaws with using the cap rate. Other decision factors should include Net Present Value (NPV), Internal Rate of Return (IRR), debt coverage ratio (DCR), cash flow, alternative cash flow, and several other decision tools.
User analysis is looking at a property from someone who intends to utilize the facilities for their own needs. Examples might be a real estate company looking to open an office, a retail store considering a location, or a manufacturing facility looking to expand. Careful user decision analysis should be conducted to determine if the user should purchase or lease the property. Cash flows, net present value, discounting, etc. are some of the decision tools. If leasing, the tenant should exercise diligence in determining if the lease qualifies as a capital lease. Capital leases will affect the balance sheet negatively when the business is looking to secure financing.

CoStar has recently called the bottom of the office market. For Hampton Roads, this has been tempered by the planned shutdown of the Joint Forces Command, which occupies hundreds of thousands of square feet of office space, mainly in Northeast Suffolk, Portsmouth, and Norfolk. However, the recession has created buying opportunities for investors.

On a national level, Integra Commercial Property Index shows that multifamily properties were the only sector to register an increase in value last quarter (2%). Integra is projecting that, aside from retail, all sectors will either hold steady or increase in the next six months. Retail is still suffering as it is closely tied to the housing market.

If you have any questions regarding commercial real estate, or topics you would like to see discussed, please feel free to contact me at tecproperties@gmail.com.

I deliberately didn’t talk about “cap rates” in the prior commercial article as I wanted the blog to be a very general introduction. I didn’t want to scare away people by using terminology, math, or accounting formulas. However, when considering investment property, whether from a seller viewpoint or a purchaser, one must examine capitalization rates, commonly referred to as “cap rate”.

Essentially, cap rate refers to the expected net return on a specific property. It is calculated by taking the gross rents (all rents, fully occupied) subtracting vacancies and credit loss (people not paying) to derive effective rents. Then all expenses, specific to the property, are subtracted from total effective rents. Note that income taxes and debt service are not included. The number derived will produce the net operating income for the property. The net operating income is then divided by the required return (for the buyer) to derive a purchase price.

GI-Vacancies/Loss=Effective Rents

Effective Rents — Operating expenses = NOI

NOI divided by expected return = Purchase Price

This is important to the seller, as well. Investment properties are priced based on cap rates (and a few other considerations). If a property is producing a NOI of $100,000 and the market expects a 10% return for that type of property, the expected sells price is $1,000,000. Thus, the seller should not expect a price of $2,000,000.

While cap rate is a very important component of commercial investment analysis, there are other considerations utilized in making these decisions. Internal Rate of Return, Gross Rents Multiplier, Cost per square foot, etc. are all analysis tools used in the decision making process. A professional who understands these calculations should be consulted when listing or purchasing investment property.

For more information, please visit my website at www.tchurchwell.com or email me at tchurchwell@gsh.com or call Tim Churchwell at (757) 251-6082.

Thinking of purchasing or leasing a commercial property? Whether you are thinking about office property, warehouse, retail, or multiuse, there are some factors that should be considered.

First consideration is intended use. Do you intend to use this property yourself? Lease it to others? Perhaps lease part of the property to others? How long do you intend to occupy the property yourself?

Second consideration is zoning. Especially if purchasing, confirm that the proper zoning is place. This should be a contingency in the contract prior to closing.

Third is the “price”. If leasing, what is your square foot price? Be sure to inquire about additional fees and requirements. CAM’s (Common Area Maintainence) usually amount to another $1.50 to $3.00 per sq. ft. Also, you need to find out if the lease is a “net lease” and what type. This means who pays for taxes? Grounds? etc.

Fourth, build out costs. At least in this area, the square footage rate is merely for the “shell”. Often, there is additional build out costs associated with getting the office, retail, etc. space to your perferences. If properly negotiated, then some of this costs can be offset, usually in the form of a “free rent” period if leasing. If purchasing, should be considered in the overall costs of your purchase.

Parking is the fifth concern and is often overlooked. You might have the perfect location and the perfect price but if you require 50 parking spots and zoning only permits 25, then you will find yourself in a bind later.

Pricing, of course, is a major consideration. Keep in mind that pricing of commercial real estate is done differently. Income analysis for existing property that will be leased out is going to be very important to any lender. Consideration for occupancy, lease rates (the subject property as well surrounding properties), are carefully examined and should be a major consideration in your offer. However, sometimes the value is in the location and the land. A class C retail space sitting on a waterfront parcel and getting high traffic might be considered for redevelopment.

These are just a few, very brief considerations when making decisions on commercial property in Smithfield, Isle of Wight, or in Hampton Roads. Let us know if we can help. Or visit our website at www.tchurchwell.com for more information.