Monday, August 10, 2015

An Expanded Valuation for Commercial Properties

- The Gordon Growth Model


The two most common methods to value an income producing property is to look at the Gross Rent Multiplier (GRM) or the Capitalization Rate (Cap Rate). The purpose of this analysis is to define these common valuation methods and expand on the cap rate method.

Gross Rent Multiplier

The GRM is calculated by dividing the purchase price by the annual gross scheduled income.

Formula:

Formula:


The GRM method is an easy way to compare properties because the numbers cannot really be manipulated, unlike net income. Even if the property were vacant, calculating a gross income using market rents is relatively easy. There are times that a real estate agent might overestimate gross income or pro forma income, but generally speaking, the gross scheduled income is a straight forward number. When comparing groups of properties, the lower the GRM, the better the deal, generally. The downside to this method is that it does not take into account the costs to own the property which includes normal expenses, maintenance, and vacancies.

Capitalization Rate

The cap rate is calculated by dividing the net operating income (NOI) by the price.

Formula:

Formula:


When searching for properties in the various databases such as the Multiple Listing Service, Costar, or Loopnet, a parameter could be that the only acceptable property would be properties with a greater than 8% cap rate. When a prospective property is found, you then re-create the net income calculation.

Example: $1,000,000 Purchase Price


Sellers Operating Statement
Adjusted Operating Statement
Gross Income:

Property Taxes:
Insurance:
Utilities:
Maintenance:
Vacancy Allowance:
Reserve:
Management:

Net Income:
Capitalization Rate:
$100,000

$4,500 (Seller’s Tax Amount)
$2,000
$3,500
$10,000




$80,000
8.00%
$100,000

$12,500 (1.25% of Purchase Price)
$2,000
$3,500
$10,000
$5,000 (5.0% of rents)
$2,500 ($250/Door)
$3,000

$61,500
6.15%

If your search parameter was to only see properties with an 8.0% cap rate or above, this property would show in the search results and after due diligence, the cap rate would end up being too low. Many buyers and sellers look at the above adjustments and argue that the vacancy allowance was too high or that they were going to manage the property themselves. These are valid comments and removing the management expense would result in a higher NOI, but the adjusted operating statement is how a bank would look at it and even though your expenses, as a buyer, would be lower. It is important to think about your financing options when considering what to pay for a property.

Capitalization Rate – Gordon Growth Model

In financial theory, a perpetuity is a set of cash flows that will continue into infinity and the formula is identical to the formula defined above for the cap rate method. The valuation method treats the income received by the property as income that will continue forever; however, there would be some amount of expected growth. As an owner of an apartment complex or office building, it would not be proper to assume that the cash flows from that building will remain constant into infinity.

The Gordon Growth Model is commonly used to value the intrinsic value of stock or firm.

Formula using Dividends:

Formula using Free Cash Flows:

rE = Required Rate of Return
G = Growth Rate
D = Dividends

Example:

rE = Required Rate of Return
G = Growth Rate
D = Dividends

Example:


As you might imagine, there were several assumptions made in the above example, but this is how cash flows are valued. This growth model is appropriate for real estate as well.

Net Income:
Cap Rate:
Growth Rate:
Value:
$100,000
8.0%
0.0%
$1,250,000
$100,000
8.0%
1.0%
$1,428,571
$100,000
8.0%
2.0%
$1,666,667
$100,000
8.0%
3.0%
$2,000,000

The key is to determine an appropriate growth rate.

In commercial leases, there are typically built-in rent increases. If you have a five unit retail center, long term tenants, and a 3% annual increase for each lease, a 3% growth rate might be appropriate. That could be overly optimistic, but for any piece of investment real estate, assuming a 0% growth rate is not intuitively valid. Even when leases do not have built-in rent increases, inferring a growth rate is valid, even if it is a nominal number.

By analyzing income properties with this method, there would be more opportunities available and the valuation would be more accurate. However, it should be noted that banks would not finance a property using a valuation done with this method. The reason being is that a bank would be looking at a relatively short term period, 5 – 10 years. This valuation would help an investor decide on a good investment based on anticipated growth.

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