How to Build Commercial Real-Estate Asset Value in the USA.
We all wish we could work less and be financially free. It is really not as hard as you think, and I would like to share with you some of the tools that can help you to build a commercial real estate portfolio so your assets can sweat for you.
Its all about building assets that generate free cash flow that increase in value over time. If you break it down into bite size chunks, it’s actually easier than you think. Creating asset value is and should be at the core of your real-estate investment strategy so you need to understand first how commercial real estate works, how it is valued and how to select an investment that you can increase the value over time. Let’s get into the basics of how commercial property is valued, and how commercial property investors create real-estate value.
**Disclaimer, this is not a formal advisory article. I encourage you to research the topic further and find your own understanding of the contents herein.
NOI, Cap Rates and Asset Value
These three key components are the most important to understand when valuing commercial real estate. If you are not familiar let me share, it’s really simple. (1) Asset value is equal to (2) Net Operating Income divided by (3) Capitalization Rates or Cap Rates. The cap rate is the non-leveraged yield (Per annum return without considering debt) you can earn from a property in an area and industry. Example, the cap rate is 10% and you buy a building without a loan for $100,000 you will earn $10,000 per annum (10% of the purchase price).
One should always consider the fundamentals: investing in a country, state, city and industry that is growing. In the USA as an example, retail property is declining because of the effects of online retail. Look for industries where disruption will Grow Real Estate value. Nevertheless, as the formula suggests, there are two obvious ways to create asset value; firstly, increasing NOI or secondly, investing in an economy where there is Cap Rate Compression (Cap rates dropping during the term of your investment).
Cap Rate Compression
When Capitalization rates are high, real estate is selling at a discount. Conversely, when cap rates are low real estate is selling at a premium. This brings me to the ideal case for a property investor. Buy at a high cap rate and sell at a low cap rate. If you buy a real-estate asset for $1,000,000 that has an NOI of $100,000 – this means you purchased at a cap rate of 10%. Should NOI stay constant for the 5 years you hold the building yet sales of buildings in your industry and area indicate that cap rates are now 8%, your asset is now valued at $ 1,250,000. Forecasting cap rates is a whole new story, however, there are experts who do make accurate predictions based on a multitude of micro and macro-economic factors.
(Below are cap rates and yields in the US economy)
What about when Cap Rates are low?
Let us look at the developed world as it is seen as a low-risk environment. The developing world has high cap rates correlating to high risk. Currently, European countries and the USA are experiencing historically low cap rates meaning the scope for cap rate compression is half a percent at most. It is important that you as the would-be investor explore the other avenues for real estate asset growth. In a similar way that cap rate compression can create growth in asset value, increases in NOI can do the same. Should NOI increase from $100,000 to $125,000 in 5 years and you sell at the same cap rate of 10%, then your sale price would be $1,250,000. The question remains: how do you increase the NOI? This is what I call “The Value Play”, your strategy for an NOI hike.
The Value Play
When you purchase a real estate asset, it may be under a multitude of unique circumstances and it is important you work a value play strategy for the particular asset. However, here are some proven strategies OrbVest use to create asset value:
1) Lease up: This is purchasing a building with some vacancy with the intent to lease up the vacancy with high paying tenants.
2) Repurpose: There can be tremendous value in taking an office tenant who pays -/+ $24 per square foot in Atlanta and then repurposing space for a Specialized medical tenant who pays up to $32 psf. There will likely be costs involved in upgrading the space for specialized tenants, therefore it is important to accommodate for Capital expenditure (CapX).
3) Escalation: You can write escalation clauses into the lease agreement for a tenant. Some industries are characterized by larger escalation agreements than others, like medical tenants who are happy to sign 2.5% to 3% escalation in the USA (well above inflation).
4) To ensure a steady flow of NOI, it is ideal to sign as long a term a lease as possible. Make sure the incumbent tenants are there to stay when purchasing a real estate and look at the quality of the lease agreements in place.
Do credit checks on all tenants. It also helps to be positioned in an economy that is landlord friendly.
(Below: Year on Year NOI growth in medical buildings in the USA)
There are 3 things you are looking for. Look for cap rate compression. Employ at least one value play. Do your due diligence. I cannot stress enough that you should have full understanding and confidence through your own research.
All this can be a bit daunting and where does one start. The above is a small part of all the due diligence that our experienced team put into researching and evaluating each deal we bring to our investors. We make sure that we present the research and value play to you as the investor, enabling you to invest like a pro.
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