Once armed with accurate historical information, you can attempt to predict the future. Based on experience and your view of the market, including the overall economy, you can project expected revenue by asking: Will occupancy increase? Will rental rates rise or fall? Are there missed opportunities for additional revenue through fees, truck rentals, retail sales or ancillary services? You can also project expected expenses by asking: Will real estate taxes increase upon sale? Will payroll be less or more? Will bank fees, insurance and management fees rise or fall?
This entire exercise is an attempt to determine the accurate net operating income (NOI) or revenue less operating expenses―past, present and future. While buyers may project future income, they determine current value by using current NOI.
Here’s a caveat: While many seem to focus solely on capitalization rates (cap rates), this is only a starting point and should not be considered a complete or full estimate of value. There are many factors a cap-rate analysis doesn’t take into account, so it should serve merely as one piece of the puzzle. Cap rate focuses on NOI over a short period of time as opposed to the entire period of ownership. Once NOI is determined, including the future proceeds from sale, we can initially estimate value by using the formula:
Value x Cap Rate
If you know any two of the variables, the formula can be solved for the unknown. For example, assume a property of 50,000 rentable square feet is 85 percent occupied and generates an average of $1 per square foot per month in rental revenue. (For this example, we’ll ignore ancillary income, which may carry a different cap rate.) The monthly revenue is 85 percent of $50,000, or $42,500; that’s $510,000 per year. If operating expenses total $200,000 annually and the market cap rate is 9 percent, the value calculation would be:
- $510,000 Revenue - $200,000 Expenses = $310,000 Income
- $310,000 Income / .09 = $3,444,444
Who or what determines the cap rate? The short answer is the market. Often it’s the threshold a potential buyer must attain before acquiring a property. For example, a buyer may have investors to whom a 7 percent return is paid. In that case, that buyer would rarely be able to acquire a property unless he purchased at a cap rate above 7 percent (unless the buyer’s analysis showed adequate return in the future to offset the difference).
In other words, market cap rates reflect what buyers are willing to pay, sellers are willing to accept, and lenders are willing to underwrite. That is correct―lenders play a growing role in influencing the market. If a buyer cannot finance a property at a specific purchase price, a transaction is unlikely to occur. There has to be adequate cash flow from the property to service the debt and meet the lender’s requirements for, among other parameters, debt-coverage ratio and debt yield. In short, there has to be enough cash flow to pay all the operating expenses, service the proposed debt and have money left over.
Other Methods to Determine Value
There are other methods for determining facility value, and it’s important to be aware of them. Here’s a brief summary:
Internal rate of return. This analysis calculates the rate earned on each dollar that remains in an investment every year, and takes into account the proceeds from the sale of the asset. It can be calculated based on purchases with or without financing. One of its advantages is it provides a measurement of the return one might expect over time, usually years.
Cash-on-cash return. This is a measurement of the return on the cash invested in a property and is calculated by dividing annual cash flow by the amount of cash invested.
Here’s another caveat: Each approach to valuation typically ignores the impact of taxes and is, therefore, “before tax.” A complete analysis should take into account the tax implications for a buyer and seller based on their specific circumstances. All of these methods of valuation can be employed when estimating value.
Dale C. Eisenman is president and broker in charge of Midcoast Properties Inc., as well as a licensed real estate broker in Georgia, and North and South Carolina. In addition to being a professional pilot early in his career, Eisenman has practiced law, owned and operated several small businesses, and has been an active commercial real estate investor for more than 20 years. He specializes in the self-storage industry as an investor and broker. To reach him, call 843.342.7650; e-mail firstname.lastname@example.org; visit www.midcoastproperties.com .