Deciding on which commercial real estate property to buy is more complex than looking at price and location. Investors need to analyze the profit potential, maintenance costs, and other quantitative metrics.
When real estate investors calculate these numbers using a pro forma, they gain insights that allow them to effectively compare deals. Investors need commercial real estate metrics listed below to create a pro forma.
Net Operating Income
Net operating income (NOI) ranks as the most important figure in commercial real estate metrics. Professional commercial real estate investors watch their NOI like hawks. Why? Because NOI is equal to cash flow.
Cash flow makes or breaks your investment. Negative cash flow pulls investors inexorably into the abyss. When properties are highly leveraged, negative cash flow sinks them even faster. Positive cash flow allows investors to continually improve the property and charge higher rents.
It also makes the property attractive to buyers, resulting in a higher sales price. Never buy a commercial real estate property without first calculating the property’s NOI.
- Calculate the potential rental income.
- Add together vacancy and credit losses.
- Subtract vacancy and credit losses from potential rental income.
- This gives you the effective rental income.
- Add the effective rental income to all other income.
- This gives you the gross operating income.
- Subtract operating expenses from gross operating income.
- This number is your NOI.
There are several ways to achieve high NOI:
- Buy in a hot location.
- Negotiate a price below market value.
- Find anxious sellers.
- Act quickly when making offers.
- Negotiate with patience.
- Short sales.
Like stocks, real estate investments have a capitalization (or cap rate), which is used to calculate an income-producing property’s value. Cap rate is one of the commercial real estate metrics that provides a useful view of the property’s intrinsic value.
Cap rates show the rate of return on a property without the effect of leverage. The formula assumes a cash price so that investors can see the unleveraged rate of return.
How to Calculate the Cap Rate
- Determine the NOI.
- Divide NOI by the market value.
This provides the financial yield over a one-year period. Investors calculate the cap rate prior to making a purchase. Property owners should seek to increase the cap rate of their properties, as an improved cap rate allows the owner to sell at a higher price.
Return on Investment
There is more than one way to calculate return on investment (ROI), but real estate investors usually prefer the cost method to account for variables like maintenance costs. However, the cost method fails to account for the effects of leverage, so the ROI remains the same whether an investor purchased the property with cash or used financing. The cost method bases ROI on equity.
The out-of-pocket method calculates ROI based on the ratio of profit to the investor’s financial contribution to the property. Because many commercial real estate deals are highly or even completely leveraged, this method greatly magnifies ROI.
Equity and leverage are important factors determined by commercial real estate metrics, but investors must also consider the impact of rents. The property cash flow method calculates ROI based on the ratio of rent collected to the investor’s out-of-pocket contributions. Low out-of-pocket contributions and high rents greatly improve ROI using the property cash-flow method.Investors monitor their ROI using this method to assess if they have a healthy commercial real estate cash flow.
Calculating ROI with the Cost Method
- Add all out-of-pocket expenses to the property purchase price.
- Divide the sum by the equity.
- This provides estimated ROI because the property may sell at a different price.
Calculating ROI with the Out-Of-Pocket Method
- Add the down payment to all other out-of-pocket expenses.
- Divide the sum by the equity.
- Because the sum is always less than with the cost method, ROI is higher.
Calculating ROI with the Cash-Flow Method
- Calculate the annual rental income.
- Divide the income by the down payment amount.
- The lower the down payment, the higher the ROI.
It’s worth noting that ROI and profit are not synonymous. Investors calculate profit after the sale of the property — when the variables are no longer subject to change. These ROI calculations provide a snapshot, indicating how a property is performing financially at a point in time.
CRE Requires Diligent Documentation and Income Data
Commercial real estate requires extensive analysis. Determining the worth of a deal requires building a pro forma. A pro forma consolidates all of the data on a property and its potential financing. It then produces an estimated NOI and cash flow.
Investors then use financial ratios to further analyze the merits of the deal and to compare one opportunity to another. Creating a pro forma starts with information gathering, which provides the numbers you enter into the pro forma calculations. Important numbers include the following:
- Sales price
- Annual rental income
- Cost of sale
- Operating expenses (maintenance, snow removal and the like)
- Any other sources of income or expenses
- Amount and cost of finance
Though the calculations are scientific, there is also some art to pro forma creation. The variables are estimates of what you believe the property will produce in the future. Bad estimates lead to unrealistic pro formas that, at the least, cause investors to overlook good opportunities.
At worst, a poor pro forma causes an investor to buy at the wrong price and experience poor returns. Pro formas require expert knowledge. Determining the correct variables requires commercial real estate pros who know the local market inside and out.
Their extensive knowledge of the environment around the property and the economic vagaries of the region allow them to determine variables accurately. A cookie cutter approach never works. Each property or area is unique.
LCI Realty helps clients create accurate pro formas for Phoenix commercial real estate. We help clients stress test their pro formas using the right assumptions and accurate data. The pros at LCI Realty love to teach newcomers to commercial real estate — how to analyze deals using commercial real estate metrics.
They also work with experienced investors who are new to the Valley of the Sun. If you’re interested in creating a bulletproof pro forma for Phoenix commercial real estate opportunities, contact LCI Realty.