For Beginners: The Basics of Commercial Real Estate (CRE) Financials
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Behind every commercial real estate property is a story to tell, and that story is told with numbers.
Before you can drop so much as a dollar into a commercial real estate investment, you need to analyze how well that dollar is going to treat you based on the property's proforma and its intrinsic value (the forecasts on future cash flows as well as the analysis of present cash flows).
You accomplish such an analysis by starting with the commercial real estate property's financials.
Some factors that go into the property's financials include cash flow, capitalization rate, net operating income, and more.
Properties Are the Sum of Their Individual Components
The value of commercial real estate property is built from the sum of its parts. Primarily, its present and forecasted cash flows that are used to construct its capitalization rate and net operating income.
Other components, such as the property's location, amenities, and square footage, also play a role in determining the overall value of a commercial real estate property's intrinsic value.
Combine this intrinsic value with the property's financials, and you have the complete property value picture.
Fundamentals of Intrinsic Value: The Net Present Value Method
Determining property value via intrinsic value is also known as a value play.
When commercial real estate developers build properties, they start by placing themselves in their customers' shoes:
- What would an average tenant of our development like to see in their building?
- What's the average household income in the area?
- What are people buying and not buying?
- What are the area's demographics? How old, on average, is the target audience?
- What makes other comparable properties in the area successful?
The answers to these questions form the basis for the property's intrinsic value: Future cash flows become predictable as the costs of these amenities are lumped into the calculation of rent and other income-producing components, leading to the property's net present value.
Net present value, in other words, is the sum of the property's current and forecasted future cash flows, with future cash flows being discounted to account for the time value of money.
Such analysis forms the fundamentals of the property's intrinsic value, but there's another way to do so.
Determining Intrinsic Value With the Replacement Cost Method
While the net present value method estimates the value of the property on the basis of present and future cash flows, the replacement cost method does so by fleshing out the costs of construction.
Such construction-related costs may include:
- Hard costs. These may include the costs for site, parking lot, and building construction.
- Soft costs. These may include the costs for obtaining appropriate permits and hiring necessary third-party consultants.
- Fees. These may include developer costs of labor.
- Financing. This may include costs for borrowing the appropriate amount of money to construct the property as well as interest paid on those loans.
Investors use the replacement cost method as a buying signal: The general rule of thumb is to buy when the price of the property drops below the property's replacement cost.
As a result, investors can also get a picture of the property's intrinsic value with this method.
Other Fundamentals of Intrinsic Value
Outside of intrinsic value calculation methods, there are other components to such value that can be analyzed with the naked eye.
These include:
- Location. A property situated in the middle of a bustling metropolitan area is intrinsically worth more than one situated in a remote, rural area.
- Square footage. The “size” of the property itself. This is used to calculate the property's price per square foot.
- Lot size in acres. This contributes to the cost per acre of the underlying land. Land by itself carries its own intrinsic value that's lumped into the cost of the properties it houses.
Investors can use these factors to complete the picture of a property's intrinsic value.
Fundamentals of Property Financials
The next chapter in a commercial real estate property's value story is its financials, the numbers on the books as well as the numbers predicted to be on those books.
This is also referred to as the property's proforma analysis. A proforma is just that: a quantifiable picture of the property's projected financial returns.
Components of the Proforma
Each individual component of the proforma analysis works together to form these projected financial returns.
Property Net Operating Income
The net operating income of your property illustrates how much money you'll make before taxes are accounted for but after operating expenses are paid.
This number also does not account for debt service.
Property Internal Rate of Return
The internal rate of return component of the proforma illustrates how much your money is growing within your commercial real estate investment.
In other words, it tells you whether the property's value is growing or slowing. If the value is slowing, this indicates that your money may be better placed within a different investment.
Property Debt Service
The debt service component of the proforma literally refers to your debt payments excluding the property's operating expenses.
Debt service gives you an idea of how much debt is remaining on the property versus how much has been paid.
Property Capitalization Rate
One of the more well-known and widely used components of commercial real estate financials, the capitalization rate gives you an idea of a property's ROI before debt service is accounted for.
The capitalization rate creates a picture of the property's net operating income (or income after operating expenses are accounted for but before taxes are taken out) against what you initially paid for the property. The cap rate is expressed as a percentage.
Property Gross Revenue
Gross revenue calculation is rather simple: It illustrates how much gross revenue you could receive when the property is 100% occupied.
Property Operating Expenses
This refers to all expenses paid to manage and maintain the property. This number will depend on the type of net lease the property offers.
For instance, with a triple-net lease, the property owner passes on 100% of these operating costs to their tenants.
Property Cash-on-Cash Return
This illustrates the property's ROI once the debt service has been accounted for.
This type of return is not calculated on the total purchase price; rather, the initial down payment you gave when you purchased the property is used instead.
How Can Understanding Property Financials Lead to a Solid Commercial Real Estate Investment?
Commercial real estate property financials are essential to understand for any CRE investment.
If you find yourself struggling to piece together this puzzle, it may be worth your while to hire an advisor. Also, you should never forego creating a commercial real estate team to help you make wise purchasing decisions.
The final chapter in this story is using these property financials to take that leap of faith and invest in the property.
But ultimately, with a solid understanding of the proforma analysis and the property's intrinsic value, the leap may not be all that perilous.
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