Commercial property managers are typically involved in the acquisition of a commercial office building. They can play various roles throughout the “due diligence” process. In the case of commercial office buildings, not only do we evaluate the physical condition of the property but we often look at some of the financial concepts such as capitalization, net present value (NPV), and internal rate of return (IRR). Many times this pertains specifically to capital projects acquisition team feels are necessary to compete with other neighboring properties and/or to protect the asset investment.
This may be nothing new to some but for others that are either new to commercial building management or commercial real estate investment, this is something you should be familiar with. It is important that you know how these terms come into play and what they mean. Below are some of the more prominent financial terms that you should have some knowledge about and how they are implemented in commercial real estate management and investments.
Capitalization is one of the factors used to determine the value of real estate. The capitalization rate can be determined by dividing the net operating income of the property by its value or the amount of the initial investment. The net operating income (NOI) is determined by subtracting the property’s operating expenses including vacancy from the income.
Net Operating Income (I)
Capitalization Rate (R) = Value (V)
Another way to express this is with the following formula: R = I/V
This cap rate is compared to the market rate to determine whether or not a particular project should be undertaken.
Let say for instance that we were evaluating a commercial property that generates $2M annually with operating expenses of $800k, the net operating income would be $1.2M. If you expect an 8% return on the property, the maximum value you would expect to pay for the property would be $15M. Simply divide the cap rate by your expected rate of return or 8% in this case.
So where do you find capitalization rates you ask? Generally a commercial property appraiser can provide or you can research sales of comparable properties. BOMI (Building Owners & Manager’s Institute) or the Institute of Real Estate Management (IREM) publishes information pertaining to financing and cap rates or you could ask one of the more prominent real estate brokers or lenders for cap rates in your area. Cap rates vary depending on the financial risks involved with a particular piece of real estate as well as the current real estate market conditions.
Present Value
Present value compares the anticipated cash flow from an investment to the initial investment. If the cash flow is higher than the initial investment, the expected rate of return will be higher and further investigation of the property should be undertaken. The present value of future cash flows is calculated using the cost of capital or the minimum required rate of return to invest in the property as the discount rate.
Net Present Value
Net present value is the excess of the present value of cash inflows generated by the property over the amount of the initial investment and can be expressed in the following formula where “I” equals the investment: NPV = PV – I
Basically if the NPV is positive you should continue with your evaluation of the property. Otherwise you should pass or move on.
Internal Rate of Return
IRR or internal rate of return is the true rate of return on a series of cash flows generated by an investment.
Payback Periods
Payback period is something you will run into more often than not when considering a capital project.
How long will it take to recoup your initial investment? The easiest way to explain this is with an example. Suppose you decide on an energy savings capital project such as replacement of light fixtures in a parking garage and the total cost of the project is $20k. However you expect to reduce the electricity costs by $4k annually. Then your payback period is four (4) years.
While the concept of payback periods is simple, remember that it does not factor in the time value of money, net present value or internal rate of return.
<strong><span style=”text-decoration: underline;”>Life-Cycle Costing</span></strong>
Life-cycle costing is a more sophisticated method of analysis used for comparing alternative capital expenditures. It is generally used for projects expected to produce benefits for a period of time longer than one year. Life-cycle costing does factor in all the current and future financial ramifications including acquisition cost, annual expenses or savings, operating costs, maintenance, personnel, salvage costs, income and present value. Sometimes people use the term, “crib to cradle” because it is all inclusive and based on Life Expectancy, Inflation Rate, Real Interest Rate, Initial Expenses, Ongoing Expenses, Discount Rate or Inflation Rate, Interest Rate and Escalation Rate. As you can see, life-cycle costing can be very complicated and comprehensive. I can only say that when we look at capital projects and investments, we do not go to this depth of analysis although we do use some of these factors.
<strong><span style=”text-decoration: underline;”>Tax Benefits & Depreciation</span></strong>
Other factors to consider when budgeting capital improvements are tax benefits and depreciation. Investments that generate income may require you to pay capital gains or other taxes. Depreciation is a benefit because it reduces the net profits before arriving at a taxable income.
Tax benefits from real estate investments and depreciation are definitely an important factor and vary with the investment structure. These to factors although not as complicated as some may think, require a good deal of explanation and more than I can write here so we will save that for another time.
Preparing for and planning a capital budget is an important part of the budget process. Capital projects should be a part of the “due diligence” process in uncovering any unknown deficiencies as well as determining the costs to complete these projects. They can be mechanical such as the replacement of a cooling tower or boiler. Maybe modernizing the elevators. Also electrical capital projects such as replacement of the main switch gear or upgrading the electrical service to the property. One of the projects I find are constantly requiring update is the fire/life safety systems such as the fire alarm, audio/visual devices. They can also be as simple but not cheap and that is replacement of the finishes in the common areas and main elevator lobby.
Curb appeal is without a doubt, one of the primary areas that should be focused upon. Planning for these projects requires that the property manager or facility manager either set aside reserves in investments to make these purchases or designates cash surpluses to make them.
In either case, property and facility managers alike must understand and apply the principle of compounding and must be able to evaluate the return on various capital projects through such means as calculating capitalization rates, payback periods and the after-tax revenues of various capital budget projects.
Learn and understand these functions and how they play a role. Practice with a few hypothetical cases yourself before applying these concepts to real situations and if you are not part of the acquisition team, ask your supervisor if you can tag along the next time they are touring a property.
