Commercial Analysis: Determining value

[Jason Howell]

Note: I'm self educating on Commercial Real Estate deal analysis, so pardon the elementary question(s) (I'm sure there will be more!) But I want to be sure I'm understanding even the basics of this correctly. I'm using Loopnet to find deals and work the numbers, it's merely an exercise to get more comfortable running numbers:

The "deal": http://www.loopnet.com/for-sale/ca/?bb=g22p8rl53Ph...

Straight away, I see the purchase price of $1.7mn. I see in their supplied Proforma that Net Operating Income is $75,720 and their listed Cap Rate is 5.11%.

When I do the formula for finding value (value = NOI/Cap Rate), I end up with $1,481,800.

What this appears to tell me is that they are charging a $218,200 premium over the value of the property when figured against a Cap Rate of 5.11%, correct? Is this an immediate indication that buying at the $1.7mn price point is likely overpaying for this particular property?

[Tyler Kastelberg]

@Jason Howell

Jason - You're on to something and I want to keep walking down this path ...

Why would investors want to purchase in low cap rate markets?

I can tell you from experience underwriting deals for a number of institutional and semi-pro investors that they have achieved IRRs greater than 15% and yields greater than 8% in markets like San Francisco, LA, NY, and DC that advertise 4% cap rates.

Markets with low cap rates typically share the following characteristics:

1) Strong rent growth, driven by

2) Strong population growth, driven by

3) Strong job growth

4) Low vacancy

5) High per bed rents (lower operating costs as a percentage of total rent)

6) Good property management options

7) Higher quality tenants (young professionals like myself will rent in SF until their late 30s to early 40s)

To achieve returns in these markets, investors buy buildings with significant value-add or development opportunities on very low to no leverage (debt), and refinancing the deal after stabilization to cash out. To execute this strategy, you need a lot of patient capital. The returns are definitely there.