This is the first of a two part post I wanted to do on commercial real estate (CRE). This first part is dedicated to appraisals and valuations. The second pertains to the investment decision itself.

A CRE’s market value is just the present value of the cash flow thrown off from the property. The formula is pretty simple:

All this formula says is the market value of the property today is the sum of the cash flows, represented as net operating income or NOI, plus the market value at some point in the future when it’s sold.

But what if you don’t plan on selling the property? Then the formula above reduces to this:

where ∞ indicates infinity. Just like in valuations of equities, the formula gets reduced to this:

where r is the rate of return, and g is the growth rate of the property. The difference, when speaking of CRE, is the capitalization rate or the cap rate.

To look at what goes into this valuation, I set up an example in a spreadsheet. As you can see, the present value of the building is about $4.5MM assuming you want a 12% return. A higher rate of return will push down the price you pay for it.

But the more interesting case is the infinite holding period valuation. First, we’ll assume the same 12% return and the 4.5% growth I used in the first one. There, it says the value of the building is $7.3MM.

But look at what happens when we adjust the growth rate up to 7.5%. The value balloons to over $12MM. Why? Because when we reduce the cap rate, we’re pricing in better growth from either future NOI being thrown off from building or from capital gains – i.e. the building’s value rising at a faster rate than at a 4.5% growth rate.

So as you can see, the cap rate can make a huge difference in what you value a property at. When you have a real estate boom and/or high inflation, you can expect to see low cap rates. In a less heated market, the cap rate is higher and you shouldn’t expect the growth rates you’d see in a more heated market. I should also point out cap rates change over time, so they’re not static. What you can infer from the cap rate at any given point in time is what market mood is like, though. If the market is ebullient, expect a low cap rate. If it’s not, the cap rate will be higher.

The problem we had over the past 5 years was that we saw a lot of CRE projects going up where residential projects went up. So assuming the residences sell, it was easy to say there wasn’t a build-up of excess CRE. And with residential prices driving land values higher and other values higher, it was really easy to price in high growth and overpay/overdevelop for a CRE project.

But now we see the effect of that sort of herd behavior and group think. A bunch of overpriced, underutilized properties on the market that won’t realize the returns assumed in costing out the development or in the assumptions made at the time of purchase. And it’s all left to go bust.

The next post I’ll put together a CRE investment scenario that walks through the CRE investment process.