There are many financial metrics that are important to commercial real estate success and I will give you just a few that are important for negotiating value.
Each piece of real estate is a business.
The most important thing for working at a commercial real estate firm is the cap rate.
The cap rate helps you negotiate the value of a piece of commercial real estate.
It’s like cash flow but it uses net operating income over the asset price. Net operating income is taking the rents minus all operating expenses. It’s what you keep. Asset price is the price that you are negotiating.
Net Operating Income = Annual Rent - Annual Expenses
Cap Rate = Net Operating Income/Asset Price
Cap Rate tells you if you overpaid for a building:
Asset Price = Net Operating Income/Cap Rate
If you have a net operating income of $20,000 and a cap rate of 5% the asset price will be:
$400,000 = $20,000/5%
But, if it’s advertised or someone tells you it’s worth $500,000 you could do the math:
4% = $20,000/$500,000
You want to get a higher cap rate for the price and market.
You would need $25,000 net operating income for that building:
5% = $25,000/$500,000
Cap Rate measures the profitability of a building. Not all websites advertise cap rate, but after you get the phone number you could ask for the cap rate.
Let’s take a look at the formula for cash flow. Because cash flow is king. Cash flow takes into account net operating income minus all expenses for interest and taxes:
Cash Flow = Net Operating Income-Interest Expense-Taxes
Cash flow is a good measure of whether people are running away with your business. It is also a good measure of how long you can stay in business for.
Let’s take a look at the yield because cash flow flows into yield:
The rate of return takes into account the price that you bought the asset for. It also takes into account the rents that you got for the building:
Yield = Annual Cash Flow/Cost Of Asset
Yield is what you measure after you purchase a building or when you own it. It’s just like a stock. When you buy a REIT fund the common metric that Morningstar will display is the yield. If you are competing versus big players you might aim for a 4% yield. It depends what market and asset class that you are specializing in, but overall the U.S. real estate market has about a 4.38% yield.
Loan to value is an important metric that banks and mortgage brokers look at when deciding whether there is enough value in a piece of property to give a loan. If you have too much debt or mortgages it’s hard to refinance into a bigger mortgage for more money. You will have to pay down debt to get another mortgage. You could go to a real estate association to find a joint venture partner to pay down your
mortgage and invest with you.
The LTV is this:
LTV = Mortgage Amount/Appraised Value
There are many financial metrics but these are just some that can help you in your negotiations and when raising money.