Valuing Investment Real Estate

The relationship between a property’s income and CAP rate is used to determine its value

Commercial properties which are bought & sold for investment purposes are valued quite differently than one purchased for occupancy purposes (so-called “owner-user” buildings). The biggest difference is that owner-users are buying the real property itself, while investors are buying not just the physical property, but also the capitalized value of future cash flows.

What is capitalization? The short definition is the assessed value of an asset based on its current and future cash flows. So an investor, looking to purchase an asset which produces positive net income, will apply what’s called a capitalization rate (or CAP rate for short) to put a current value on future cash flows.

The graphic shows the relationship between a property’s income, value, and the CAP rate used to determine the value.

In this formula, Income represents the net operating income of a property, which is the gross income less operating expenses (excluding taxes and debt service). Rate is the CAP rate we discussed above, and the Value is the price that an investor might be willing to pay for those cash flows. The great thing about this formula is that if you know at least two of the variables, you can always determine the third through simple multiplication or division.

So on the investment property market, often the first litmus test will be the CAP rate. Investors will want to purchase at a high CAP rate (meaning a higher ratio of net income to purchase price), and will want to sell at the lowest possible CAP rate. Oftentimes the greater the financial strength of the tenant, or the length remaining on the lease will drive down the CAP rates as they present less “risk” than smaller tenants or those on a shorter term lease.

Single tenant investments which are “net leased” to national tenants on a long-term basis are some of the lowest risk real estate investments, and thus command some of the lowest CAP rates out there. On the other hand, a building with several local “mom & pop” businesses is one of the higher risk investments, and thus trades at a much higher CAP rate as a means of offsetting that additional risk.

As a broker, knowing our clients’ risk tolerance is a good tool for finding the right investment property for their specific goals. Younger investors may have a higher tolerance for risk, if that means they have the potential for realizing higher gains, while the older investors may trade performance for security of their investment and its cash flows.

In summary, matching clients with the right investment properties for their portfolio is of the utmost importance. That’s why at Bradley Scott CRE we take the time to meet personally with each client for an in-depth review of their financial position and long-term goals. Let us do the same for you and show you what investment options most closely match your family’s goals today!

 Cameron Wilson is director of brokerage and business development at Bradley Scott. He can be reached at (360) 479-6900 ext. 219.