The valuation of commercial real estate depends on multiple factors that are intrinsic to the property and are processed through a metric that could use the comparable sales approach, the cost approach, or the income capitalization approach to determine its value. Historically, the income approach has been considered the most effective method of obtaining the value of income-producing real estate, especially from an investor’s perspective. Even the old adage that the three most important aspects of real estate are “location, location, location” also depends on the income that has been or could potentially be generated on the site. The proximity of the location to vital infrastructure, the central business district, schools, major highways, etc. it will affect its desirability, the quality of tenure, and the market rents that can be dictated or expected. However, the structural integrity and functionality of the property for its intended use, e.g., multi-family, office building, industrial, commercial or mixed use, to name a few, play an essential role in its ability to be a revenue-generating instrument. income.
The motivation to enter the commercial real estate market as an investor is generally driven by cash flow; This differentiates the impetus from owning owner-occupied commercial real estate as a place to conduct one’s primary business or buying a home that represents family abode, pride of ownership, and a place to make memories for the future. The complexity, risk, and illiquidity of a person’s capital during the property acquisition and management stages, which only becomes liquid on the disposal or withdrawal of cash: refinancing guarantees a premium to compensate the investor for assuming the risk with its capital in the arduous structuring conditions. the most effective use of equity/debt capital budgeting in relation to market unpredictability and local market instability. To achieve this goal, it may be prudent to perform a discounted cash flow analysis to determine the most effective capital allocation in a trade or whether the trade is worth consuming based on the due diligence findings. The investor is essentially buying an income stream; commercial real estate as an asset class has the added benefits of asset appreciation (usually), debt reduction from income generated to pay down debt (mortgage), and tax write-offs, including depreciation expense, which reduces taxable income and increases cash flow. Typically, a Pro Forma is prepared for the projected holding period reflecting expected income and expenses under current ownership if it is a refinance or new ownership if it is an acquisition. The investor then determines what discount rate they believe is acceptable to justify and offset the risk of tying up capital based on project risk, risk premium, cost of debt, and the local and general economy.
Discounted cash flow analysis used in commercial real estate is synonymous with discounted cash flow capital budgeting methods. The Net Present Value (NPV) and the Internal Rate of Return (IRR) are used to determine the feasibility of a project. The NPV method discounts the future cash inflow to investors’ cost of capital to determine the present value of the investment. This is then compared to the current cost of making the investment. The Internal Rate of Return (IRR) determines the yield that equals the present value of the cash inflows and outflows of the investment. This return is then compared to the cost of capital required to make the investment. An alternative method of determining value used in the income approach to valuation is to use the current net operating income (NOI) of a project or the expected net operating income of investors under new management and divide this number by a capitalization rate (cap rate). which takes into account a safe rate of return, e.g. a five-year US Treasury plus a risk premium for the project, etc., a critical rate to justify the investment and provide a valuation of the property.
Value = net operating income/cap rate
The net present value method has been referred to in the previous two paragraphs in the general description and implementation of the Discount Cash Flow Analysis. The internal rate of return is another method used by many investors to help decide if a real estate project is worth pursuing. The goal is to calculate an overall return on investment (ROI). This is accomplished by using the current operations of the property and projecting its future returns. This rate calculates the dollar invested, when it is invested, and gives a return based on when the cash flows are received and the anticipated income from the resale cash flow. This criterion can also calculate profitability after taxes. This performance can be used to compare various investment opportunities. However, this method uses assumptions and is only as good as the “garbage in, garbage out” assumptions used. Therefore, the astute investor must project multiple possible outcomes, including high, moderate, and low returns, consistent with best-case, most-probable, and worst-case scenarios.
Sometimes individual investors’ and business entities’ confidence in and preference for specific valuation models and methodologies can be attributed to experience, industry standards and what is consistent with the investment objective. Several methods are often used, for example, Net Present Value and Internal Rate of Return are used to analyze the financial viability of a real estate deal to see if it meets applicable investment standards determined by investment managers. However, most professionals rely more on a specific method and use others as secondary instruments that support or do not support the main method. In the event that the investment meets or exceeds the desired return through multiple methods, if all other facets of the deal are supported by due diligence, it will be pursued and consumed if there is an agreement of mind between the buyer and the seller.
