Analyzing commercial real estate is not nearly as complicated as it may at first appear. In fact, once you have the basic information about the property, analyzing the deal can be done quickly and easily if you understand the 5 basic terms.
- Income and Expenses: The income is all the money produced from the property (rents, etc) and the expenses are all the costs involved with owning and maintaining the property excluding the mortgage payment.
- Net Operating Income (NOI): This is how much money the property brings in before paying the mortgage, or income minus expenses.
- Cash Flow: This is actual profit you make, or the NOI minus the mortgage.
- Cash on Cash Return: This describes how fast you get your down payment money returned to you, or Cash Flow divided by your down payment.
- Capitalization Rate (CAP Rate): This is a simple metric used in commercial real estate that compares the sales price to the NOI.
In the following video, you’ll learn all about these 5 key terms as well as an example of a deal with real numbers. Here’s analyzing commercial real estate quickly and easily:
Here is a summary of what you learned in the video above:
Analyzing Commercial Real Estate Quickly and Easily
Commercial real estate is not as complicated as you think it is
3 Things You Want to Know About the Commercial Real Estate Deal You are Analyzing (0:32)
- How much money does it make
- What is your return on investment
- How does this investment compare to other investments
5 Key Investment Terms for Commercial Real Estate
Income and expenses
- Every commercial property has both
- Income can be rents collected, lease payments, laundry income, and even late fees
- Expenses are insurance, taxes, utilities, repairs, landscaping, and property management fees
- One thing that is not included in expenses is the Mortgage payment
- It is a debt expense
Net Operating Income (NOI)
- Definition: Your income minus expenses
- One of the most important terms of these five
- As your net operating income go up your cash flow and the value of the property go up
- When it goes down so does the cash flow and property value
Cash Flow
- Definition: Your NOI minus your mortgage payment
Cash-on-cash return
- How fast is your money moving
- If you get your money back in 1 year it is 100% cash-on-cash return
- If you get your money back in 2 years it is 50% cash-on-cash return
Capitalization Rate
- “Cap Rate” is NOI divided by the sales price
- If you pay all cash for your investment what would be the return on that investment
- 500,000 property bought outright now mortgage, what is the return on that property?
- High cap rate property will be in a low to moderate income neighborhood
- The higher you go the higher the risk the higher the potential return but the price is lower
- Low cap rate is in a wealthier neighborhood
- Lower cap rate is a lower risk, but also lower return and higher sales price.
Rules of Engagement for These Five Key Terms (10:06)
- Do not make an offer until you calculate each of these terms
- For income and expenses you need the income to be greater than the expenses
- The NOI needs to be greater than the mortgage payments
- Cash Flow needs to be positive
- Cash-on-cash return must be greater then or equal to 10%
- Cap rate should be greater than or equal to 8%
EXAMPLE (11:43)
3 Assumptions for This Example:
- The property purchase price is $450,000
- Down payment is 10% so $112,500
- Mortgage Payments are 20,000 per a year
- On this property the income is 48,000 a year
- Expenses are 12,000 a year
- This means that the NOI is 48,000 – 12,000= 36,000
- Cash flow is 36,000(NOI) – 20,000 (Mortgage) = 16,000
- Cash-on-cash return is 16,000 (cash flow) divided by 112,500 (down payment) = 14%
- Cap rate is 36,000 (NOI) divided by 450,000 (sales price) = 8%
Great presentation! Using the information presented here, how will one determine the purchase price of a commercial property assuming the financial data used for your calculations was given to you by the seller?
That depends on your required investment returns along with how motivated the seller is and how much better of a price, relative to the area’s cap rate, you can negotiate.
11/30/2019
Great!! thank you so much!!
Great tutorial on commercial real estate, for all levels in the industry! Great job, keep up the good work!
Thank you for lending your knowledge about how to analyze investment property. I am motivated to learn more before I take on my initial investment property .
Thank you Peter looking forward to meeting you in the near future.
Peter thank you so much for this presentation you clarified much for me I knew much of this but you cleared up fogginess in my understanding. thanks again
How do I go about finding the highest and best for my corner commercial lot? I hear the term slot but no one seems to be able to give a good explanation or formula.
Unebeilvable how well-written and informative this was.
Very energetic post, I liked that bit. Will there be a
part 2?
How do we determine the increase in value that a particular investment would bring? For example if I own a commercial building, which I operate my business out of, and want to consider an energy efficiency retrofit to reduce my operating expenses…. How would I determine the various metrics that are associated with this investment? NOI, IRR, Cap Rate, and the increase in property value?
Your Business and the your Commercial building represent separate business activity. They are to be treated separately. You are Tenant in your commercial building and you should pay rent to the building. Your commercial building should have a policy for charging rent and expense pass-through based on variables such an energy efficiency, degree of risk being carried, income neighborhood, Market rate, Zoning regulations and and other dynamic and emerging issues particularly on the demand and the supply side of the business. A reduction in the operating expenses of running the commercial business such as the utilities will positively impact the NOI and same with IRR, Cap rate and other metrics. By how much or in what degrees will depends on the goals and the scenarios being faced with.
Hope this help ?
Thank you Mr. Harris, vary Informative,thanks for sharing your knowledge
Can you discuss the importance of Return on Equity as opposed to Cash on Cash Return after year 1? Is it true that as you build equity through appretuon and debt paydown that your return on equity decreases and it would be wise to sell that asset so that you can deploy the funds into a property where you will realize a greater return? Great info!
Thanks
Great question. Here’s a clear explanation to your first question: If you bought a property that’s below market value, your equity at Day 1 will be higher than your cash investment (right?). This causes your Return on equity to be lower than your cash-on-cash return. Now, for Year 1, the actual difference can be huge. For your second question, it all depends on what your investment objectives are. can’t answer that yes or no. Great questions and keep’em coming.
AWSOME!!!! Mr. Harris. Thank you very much. I am new to CRE and I started to learn how to begin mastering in this field of real estate. Thank you again.
Hi,
Great Tutorial. Is it True that a higher cap rate is risky? like a 12% cap, is that associated to a Class A building? Please explain.
Thanks