Commercial Real Estate’s Misleading Numbers

Posted: February 27, 2014

Two men were examining the output of the new computer in their department. After an hour or so of analyzing the data, one of them remarked: Do you realize it would take 400 men at least 250 years to make a mistake this big?

The point is — if you start with bad data or false assumptions, the conclusion reached isn’t all that beneficial.

To be sure, there are plenty of opportunities for both when assessing commercial real estate, but here are a few I’ve seen most often and how you can avoid by focusing on the right inputs.

A Moment In Time

A capitalization (cap) rate is a ratio between net operating income (NOI) and its current market value.

To many, a cap rate seems like the ultimate valuation tool for investment property. After all, the equation considers a price, income generated and operating expenses, ultimately expressing the data in the form of a percentage that is as simple as an interest rate and just as easily compared.

However, underneath its seeming simplicity, a cap rate can hide a whole range of potential pitfalls.

In theory, reaching a property’s NOI, which is the basis for the cap rate, is simply a matter of subtracting all operating expenses (excluding debt and one-time capital expenses) from the income generated by the investment. Too often, it is just theory, because sellers and investors are not considering all expenses —  instead only including items like taxes, insurance and maintenance when establishing a purchase or offer price based on a cap rate.

This ignores major items like property management, capital reserves and vacancy, among others; all of which are real expenses that have a dramatic impact of the performance of the investment.

Even an accurate cap rate isn’t a very useful tool if used in isolation. Cap rates are like a picture — it is a moment in time merely illustrating how the property operated in the past. It doesn’t provide any sense of future performance, which is important unless you only plan to hold the investment for that singular moment.

A solution exits in performing the proper research and financial analysis. A competent broker will assist in this process by calculating a “true” cap rate taking into account vacancy, maintenance reserves, management, and more.

After all income and expenses are taken into consideration your broker should then go further with tools like discounted cash flow analysis and modified internal rates of return to project how the building can actually perform over time.

The Greatest Offender

I’ll admit, I’m on a bit of a crusade. It’s nothing personal against assessors. Just the opposite, the overall assessed value to market price ratio in our area bear out that assessors do a very good job. It’s just the result of their work isn’t being used appropriately and it is costing (and sometimes making) buyers and sellers of commercial real estate money. 

By far, the biggest drawback associated with using an assessed value to set pricing or make an offer on commercial real estate is that the assessed value may just not be accurate for your purposes. Keep in mind, all an assessment is designed to achieve is a valuation model that produces equitable distribution of tax liability, not valuation.

If you want to know the market value — get an appraisal or broker’s opinion of value. They’re not perfect, but if you’re going to base a decision on an estimate — at least make it one that is timely, contains full information and was developed specifically for your property of interest.

The Price Isn’t The Cost

Selecting a business location is seemingly a fairly simple proposition. It’s just a matter of picking the best location at the lowest possible price. Price is generally a reflection of demand — and demand for commercial real estate is driven by a series of factors including parking, visibility, activity, traffic, accessibility, suitability for use and price.

Most of these factors contribute to the singular purpose for commercial real estate, which is to generate revenue.

A business can make money off adequate parking and neighboring businesses, but not the cost of rent — it is just an expense.

This is not to say price isn’t important. Of course it is, but it is almost a certainty for retailers and restaurants that a cheap location with no visibility or bad access is going to cost more than one with a higher rent rate and comparatively better visibility and access.

Simply, price should be a factor, but it shouldn’t be the most important factor.

Sometimes, price isn’t even what it appears. For many, the most familiar number associated with leasing commercial real estate is what is known as the base rate. That is, the advertised rate for a commercial space, say $12 per square foot per year.

However, there are two additional components to which any potential tenant will want to pay particular attention.

Common area maintenance — CAM — is an annual fee charged at most locations often to cover real estate taxes, insurance, and well, the maintenance of common areas. Depending on the services provided, the fees can vary widely from $0.50 per square foot to $6 per square foot and will have an impact on the total cost of occupancy. Likewise, the expense of leasing space will be increased by rental escalations (also known as percentage increases/bumps).

Rental escalations can come in the form of percentages, flat fees, or be tied to an index like CPI, but they all have the same effect of increasing the rate over time.

The goal for any lessee of real estate should be to calculate the total cost of occupancy. This includes not only the base rate, but also additional rent like CAM and other components such as rental escalations.

Calculating these expenses over the lease term provides a solid number to compare against other potential locations and coupled with appropriate site selection methodology will allow you to determine the cost rather than just the price.

Without question, commercial real estate is a numbers business. Most decisions can be distilled into an equation. Some of these equations have gained so much popularity that they are used as “rules of thumb.”

Of course, there is nothing inherently wrong with a rule of thumb — until there is — and you likely don’t want that to occur within the context of a decision worth several hundred thousand dollars or more.

Tim Reamer provides commercial real estate brokerage and consulting services with Cottonwood Commercial and specializes in investment property (multifamily | commercial | NNN), retail/restaurant site selection and commercial buyer/tenant representation. Learn more at www.timreamer.com.