Key Takeaways.
Income-producing real estate returns come from two sources, tenant rent and property appreciation. To achieve both, it is necessary to have many components in favor, but three of the most common are: the 1) cost of capital in the market, 2) access to jobs, and 3) occupancy rates.
The risk free rate is the interest rate offered on a 10-year United States Treasury Bill. Since commercial real estate is considered to be a riskier investment than a treasury, the return rate on these investments moves relative to the risk free rate and investor requirements.
Jobs are one of the main drivers for every market. People follow jobs and companies follow people. The more people there are, the greater number of businesses needed to support them.
Commercial Real Estate Valuation Overview
Commercial income-producing properties are typically valued based on the amount of Net Operating Income (NOI, cash produced after operating expenses). NOI is calculated by taking a property’s rental income and subtracting its operating expenses (before mortgage payments or non-necessary expenses for the property's operation). The more NOI a property produces the more valuable it is, ceteris paribus. The estimated value of that income (read: property) can then be calculated by dividing the NOI by a Capital Asset Pricing rate (a.k.a. CAP Rate). The CAP Rate is an estimate of the annual return that an investor would expect to earn should they purchase the property with all cash.
For example: a property produces $100,000 in NOI. Investor A desires a 10% annual return; then the property would have a value of $1,000,000 ($100,000/.10). However, Investor B desires an 8% annual return; then the property would have a value of $1,250,000 ($100.000/.08). In short, the three basic components of a property’s estimated value are: income, expenses, and required return rate.
Cost of Capital (Interest Rates)
All investments contain risk, but the purchase of a 10-Year United States Treasury Bond is considered the definition of a “safe harbor”. Payment of any obligation is backed by the United States Government and the interest rate paid is commonly referred to as the “risk free rate” (RFR). CAP rates paid for an income producing asset are typically relative to this benchmark.
To put this in quick perspective, a commercial real estate asset is considered to be riskier than a 10-year Treasury Bond. As such, investors require compensation for taking any additional additional risk. The amount of this compensation is the “risk premium” and depends upon an individual investor’s perception of the risk in each opportunity being underwritten.
The RFR is not static and it changes as global factors change. For historical perspective, the RFR has fallen from approximately 15% in the 1980s to a low of about 1.2% in 2021. Therefore, if the risk premium stays the same, the CAP Rate that an investor is willing to pay for a property also goes down: a 3% risk premium in 1980 means that an investor would pay an 18% cap rate for a property; that same premium in 2021 would equate to a 4.2% CAP on the same asset – a significantly higher price.
Access to Jobs
The connection between jobs and the real estate sector may not seem direct, but at the root of every strong commercial real estate market is a strong job market. People follow jobs; companies follow people; value follows both.
However, not all jobs are created equal. Cities like Orlando and Las Vegas have historically strong job creation numbers, but the jobs tend to be relatively low paying and tied to the service industry which is notoriously cyclical. Other cities like Denver, San Francisco, and Nashville also have strong job creation numbers, but they tend to be of the higher paying in the technology, energy, and financial services which tend to be more resilient during an economic downturn.
Strong job markets attract people seeking those well-paying jobs. An influx of more people requires more businesses and services to support them - services, retail, and office ultimately driving self-storage, healthcare, and multifamily as well. The basic rules of supply and demand dictate rising prices in the strongest markets.
Surrounding Occupancy
Commercial real estate values, much like other assets are based on supply and demand. If a property has a high vacancy rate (low occupancy rate) it can mean that there are variables that may be preventing the market from absorbing the space. Two of the most common issues for this are pricing (the asking rate of the space in the market) and utility (if the space can be used for current tenants based on how they operate).
If these two are indeed driving vacancy, then the development of new properties in that market is unlikely: no demand = no new investment. Conversely, if an area has a high occupancy rate there will be few alternatives for tenants searching for space: high demand = new investment. Understanding what the total value of a market is what makes a successful Broker or Investor in commercial real estate; or any investment for that matter.
Summary
When investors and owners have an understanding on both market factors and mathematics behind calculating values, they will have a more accurate picture of the value and potential risk/return profile of their investment opportunity.
Interested In Learning More?
Cornwell Corporation is a commercial real estate services & private equity investment firm with offices in Scottsdale, Az. and Doylestown, Pa. We leverage experience, capital, and technology to find value in commercial real estate and growth opportunities. For more information, please contact us at (480) 951-1212 or info@cornwell.co.
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