The value of a commercial property is in direct proportion to the income it generates.
What, or who determines price and rental?
In determining the value of a residential property, many factors are taken into account: size, age, and condition; number of bedrooms and bathrooms; views; susceptibility to wind, flooding, and hurricanes; proximity to desired services such as shops; close proximity to undesired features such as freeways; crime statistics; school district; and zoning restrictions.
Furthermore, the value of this property will not be affected by whether it is tenanted. You could even argue that its value might be less if it is tenanted, on the basis that if the buyer wants to occupy it, he must first get rid of the tenant, something that may not be easy to do in many jurisdictions. Generally, however, a four-bedroom, three-bath-room property in a good area is worth the same as any similar property nearby, tenanted or not.
Do the maths
This brings us to our first formula, which will put things into perspective:
This formula simply says that the return we can expect from a residential property is the rental income divided by the purchase price. For example if a property costs R1 million and the rental income is R50 000 per year, then the ROI (return on investment) is 5%.
Now ask yourself, what determines the rental income for this property? Can the landlord dictate how much the rent will be? Of course not – the market determines the rent. If the landlord overcharges, the tenants will leave in favour of a similar property at a lower rent. Therefore, rental income is determined by the market.
What about the purchase price? The landlord cannot choose the purchase price, because it is also determined by the market. A buyer might find a bargain, but generally, he or she will have to pay a fair market price for the property. Consequently, the return our residential investor can expect from this, or any other property, is entirely determined by the market. The return is the quotient of one market-determined factor (the rental income) divided by another market-determined factor (the purchase price). There is very little our residential investor can do, even using creativity, talents or skills, to improve his or her return.
Factors determining commercial property values
Commercial property is entirely different, and the following formula applies:
This formula says that the value of the property is simply the net annual rental income that it generates, divided by the applicable capitalisation rate – generally referred to as the cap rate. The cap rate is the rate at which you capitalise the rental income to arrive at the capital value.
Let us assume that investors will only buy a property if they can earn a 10% return on their capital every year. In other words, if they invest R8 million, they want to earn an R800 000 return every year. Now assume an investor is looking to buy a property, and only knows that the property is generating R800 000 of net profit per year. It does not matter what was paid for it originally, if he or she wants to see a 10% return, they should not offer more than R8 million for it.
Can commercial property investors decide what cap rates apply to their properties? No, as cap rates are determined by the market. In essence, the market cap rate for a particular property in a particular area is the average of all the ROIs for which similar properties in the area have been selling. So, if the previous ten sales all showed a ROI of 10%, then the market cap rate is 10%.
Earn higher returns than market average
Thus, with market cap rates at 10%, if you find a property for sale with a ROI of only 8%, then this is not a good investment, as you could earn a higher return elsewhere. Conversely, if market cap rates are 10%, and you find a property with a ROI of 13%, then this is a good investment, as you are getting a higher return than the market average.
Another way of looking at this is that if cap rates are 10%, and you can buy a property with a ROI of 13%, it is a good deal, because in theory, you should be able to sell that property at a cap rate of 10%. For instance, a property purchased at around R5.7 million (a 13% return) is a good deal because you should be able to sell it for around R7.4 million (a 10% return). Even if you do not sell, it is still worth almost R7.5 million (because your rental income is around R750 000 and market cap rates are 10%), and because you are only paying R5.7 million, you have instant equity.
The Big Apple
Realise, however, that cap rates are not the same everywhere and at all times. Investors covet real estate on Wall Street in New York because one will always find tenants willing to pay a high rental to be able to boast that their offices are on the most famous street in the financial capital of the world. Cap rates on Wall Street are, typically, around 5%, meaning that earning a rental of around R800 000 per year, an investor would be willing to pay around R16 million (R800 000 divided by 5%).
The Small apple
Conversely, in a small town in the middle of nowhere, cap rates might be 25%, meaning investors would need to see a return of 25% before investing in a town with considerably less appeal than Wall Street in New York. In this case, a rental income of around
R800 000 would mean the property was worth only around R3.2 million (R800 000 divided by 25%).
Low cap rate equals high capital value
If you are new to the concept of cap rates, it may seem confusing at first, especially since a low cap rate equates to a high capital value, and a high cap rate equates to a relatively low capital value. Persevere, as what we are discussing will form the basis of your commercial property successes.
Let us refer once again to our formula for commercial property:
Based on this formula, there are only two ways to increase a property’s value. One is to increase the rental income. The other is to lower the cap rate. There are many ways to increase income, and if you are creative and manage to double the income generated by a commercial property, the value of that property essentially doubles.
Try that with residential property! Even if you managed to double the rental on a house or, conversely, if you lost a tenant and the rental income went to zero, you would still be able to sell the property for about the same price, because the value of a property is determined by what other properties of similar size, features, age, condition, and aspect command. With houses, the rental income is determined by the market, and the value of the house is determined by the market.
On the other hand, the value of a commercial property is the net annual rental income divided by the cap rate. In other words, the value of a commercial property is in direct proportion to the income it generates. When you double the income, you essentially double the value – a recipe for making a fortune.
Wait for cap rates to fall
Another way to increase the value of a property is to wait for cap rates to fall. Cap rates do not remain static. In general, when the market is strong, cap rates fall (since investors are willing to accept lower returns in a strong market). Conversely, when the market is weakening, cap rates rise (as investors want higher returns to compensate for the increasing risk of investing).
Assume a property makes around R800 000 of profit in rental income per year, and you bought it for R8 million at a time when the market cap rate was 10%. In this case, you would have bought it at its prevailing market value (R800 000 divided by 10%). If the market is strengthening and cap rates fall to, say, 8%, then without changing the rental income, or painting the building, or doing anything else, the value of your property will have risen to around R10 million (R800 000 divided by 8%). Realise that we cannot force the cap rate to go lower (or higher), as it is determined by the market. However, if the market is strong, cap rates tend to fall, and if the market is weak, cap rates tend to rise.
Clearing the confusion
Most people become confused with the concept of cap rates, because commercial property brokers freely use the term to refer to the return on a property investment. For instance, a broker may tell you that a property is ‘selling at a cap rate of 11%’. This, of course, has little meaning until you know what the cap rates for similar properties in the area are. After all, if market cap rates were 7%, and you were offered a property at 11%, you would have a good deal; whereas, if market cap rates were 15%, then a property returning 11% would look like a lousy deal – and yet in both cases, the market return was the same, 11%.
For commercial property brokers to say a property is ‘selling at a cap rate of 11%’ may not be entirely incorrect, but I feel it is misleading. The brokers are saying that the cap rate is the rental income divided by the asking price, but this hides how the asking price came about. If, instead, they said ‘the property is being offered at a return of 11%’, then this at least gives people an indication that they should find out what market cap rates are.
Therefore, I prefer you to think in terms of ‘this property is being offered at a return of 11% in a market where prevailing cap rates are 10%’. Use the terms return or ROI to describe what the returns are when presented with a given rental income and a given purchase price. Use the term cap rate when you want to extrapolate what a property is worth, given a certain income.
Thinking in this way will help you make millions in commercial property. To reiterate, the ROI is the net annual income divided by the purchase price. The cap rate is the rate at which you capitalise the income on a commercial property to arrive at the property value. Cap rates are entirely determined by the market.
By Dolf de Roos – Soruce: http://www.reimag.co.za/2014/05/27/how-to-earn-higher-returns-than-market-average/