Valuing Cash-Flow Real Estate - Part I
Cash-flow real estate is valued using a simple calculation:
Net Operating Income (NOI) divided by Capitalization (CAP) Rate equals Value
A property that generates $1,000,000 in NOI valued at a "10 CAP" has a Value of $10,000,000. Further;
Operating Income less Operating Expenses equals NOI.
Rental Income is the primary source of Operating Income. Rental Rates and Occupancy determine Rental Income. Operating Expenses represent the costs necessary to operate and maintain a property in normal condition.
All else equal, increases in NOI lead to increases in Value.
It is that simple. Every year, billions of dollars worth of real estate is bought and sold using this calculation. There are hidden risks in this simple calculation. Relatively small changes in each variable result in significant changes in Value. The calculation assumes historical results will continue into the future.
| Assumptions: | |
| Building Square Feet | 100,000 |
| Rental Rate (per square foot) | $20 |
| Occupancy | 90% |
| Operating Income | $1,800,000 |
| Operating Expenses | $800,000 |
| Net Operating Income | $1,000,000 |
| Cap Rate | 10% |
| Implied Value | $10,000,000 |
Rental Rates
Rental Rates reflect the price tenants are willing to pay to occupy space in a building, which is a product of the supply and demand of comparable space in a given area.
Let's assume you are considering an investment in the example property at a purchase price of $10,000,000. The current Rental Rate is $20 PSF. In your research, you notice comparable spaces available for rent at $18 PSF. If we adjust the valuation calculation to reflect an expected Rental Rate of $18 PSF, the value of the property decreases by $1,800,000 to $8,200,000. Changes in the opposite direction produce a similar result. Adjusting Rental Rate to $22 PSF increases value by $1,800,000 to $11,800,000.
A disconnect in the Rental Rate for a particular property and the market in general can occur for many reasons:
- Current leases were signed at a time when rental rates were higher (before an economic downturn, for example)
- New construction has added supply to the market
- Tenants agreed to a higher rental rate in exchange for ancillary benefits, such as a specialized build-out of their suite paid for by the landlord
Here's the takeaway. Understand the market for comparable space for the property you are considering acquiring (or investing in). Understand the outlook for future supply and demand of comparable space in the market. Generally, acquire properties with rental rates at or below market rates. The biggest risk is acquiring a property with rental rates that decrease over time (recall that the Value calculation assumes historical trends continue into the future). Such properties are not off-limits as an investment, though