The valuation of commercial real estate depends on multiple factors that are intrinsic to the property and 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 realizing 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 can potentially be generated on the site. The location’s proximity to vital infrastructure, central business district, schools, major highways, etc. it will affect your 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, for example, 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 cash flow driven; this differentiates the impetus for owning owner-occupied commercial real estate as a place to conduct one’s primary business or purchase a home that represents a home for family, pride of ownership and a place to create memories for the future. The complexity, risk, and illiquidity of an individual’s capital during the property acquisition and management stages, which only becomes liquid upon disposal or withdrawal of cash: Refinancing warrants a premium to compensate the investor for assuming the risk with your 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 discounted cash flow analysis to determine the most effective allocation of capital in a deal or whether the deal is worth consuming based on 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 (generally), debt reduction from income generated to pay off debt (mortgage), and tax write-offs, including depreciation expense, which reduces taxable income and increases cash flow. A Pro Forma is typically prepared for the projected holding period reflecting expected income and expenses under current ownership if refinancing or new ownership if acquisition. The investor then determines what discount rate they think is acceptable to justify and offset the risk of tying up capital based on project risk, risk premium, cost of debt, and local and general economics.
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 viability of a project. The NPV method discounts the future cash inflow to the 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 return that equals the present value of the investment’s cash inflows and outflows. This return is then compared to the cost of capital needed to make the investment. An alternative method of determining value that is used in the income approach to valuation is to use a project’s current net operating income (NOI) or expected net operating income from investors under new management and divide this number by a cap rate (cap rate). that takes into account a safe rate of return, for example, a five-year US Treasury bond plus a risk premium for the project, etc., a hurdle rate to justify the investment and provide a valuation of the property.
Value = net operating income / capitalization rate
The net present value method has been referred to in the two previous 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 undertaking. The goal is to calculate an overall return on investment (ROI). This is accomplished by using the property’s current operations and projecting its future returns. This rate calculates the dollar invested, when 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 return 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-likely, and worst-case scenarios.
The confidence and preference of individual investors and commercial entities for specific valuation models and methodologies can sometimes be attributed to experience, industry standards and what is compatible with the investment objective. Various 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 business to see if it meets applicable investment standards determined by investment managers. However, most practitioners rely more on one specific method and use others as secondary instruments that either support or not support the primary 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 minds between buyer and seller.
