If you are just getting into commercial real estate investing, this article has some of the most important information you need to know from the beginning. If you have taken any commercial real estate training, I hope the first thing you were taught is that commercial real estate investing is about positive cash flow.
Positive cash flow has always been important in the commercial sector and it’s especially true today. It doesn’t matter if your overall investment strategy is to buy and hold or to flip properties. In the residential sector, house values are calculated based on what neighboring properties sold for. In the commercial sector, the two most important valuation tools are net operating income and the capitalization rate.
Be Realistic About NOI
Net Operating Income (NOI) is at the heart of valuing a commercial property. NOI based on current expenses should be the first calculation you make when evaluating a potential commercial investment. Since NOI is gross income less all expenses except debt service, you need the income and expense information from the current owner. Go over both the expenses and income information thoroughly. Make sure all expenses are included. If the property doesn’t have positive cash flow, you can stop right there.
If the property does have positive cash flow, calculating the NOI from the current owner’s numbers is only the beginning. Next, you need to consider if you owned the property how you can increase income and decrease expenses to improve the cash flow. Be realistic about this. In today’s economy, you’re not likely to raise the rents by 50% overnight. Also, consider if the expenses will change under your management. Will insurance costs go up or down? Same for maintenance and other expenses. Will you be making any capital improvements?
Include Debt Service
Once you have a realistic NOI based on your own numbers, you need to consider how much your debt service will be if you buy the property. When you know how much you will be borrowing and the interest rate, you can use an online mortgage calculator to determine your monthly loan payment and multiply by 12 to come up with the annual debt service cost. Now, subtract that from your own NOI number to determine if the property still has positive cash flow.
If the property still has acceptable positive cash flow, you move on calculating the cap rate. This is the NOI divided by the sales price. This tells you the return on investment if you paid all cash for the property. A cap rate in the mid teens is considered a good cap rate. It’s not likely you will pay all cash for the property so you need to compare the cap rate to the interest rate you will pay on the loan. If your cap rate is 16% and the interest rate is 9%, you have a healthy spread between the two indicating this is a good investment opportunity. Another way to use the cap rate is to compare it to another property you are considering purchasing. Generally, the property with the higher cap rate is going to provide you with a higher cash flow.
Another important use of the NOI is calculating the debt service coverage ratio (DSCR). The higher this ratio is, the more positive cash flow the property has. Generally, you need a DSCR above 1.25 to be approved for a conventional commercial loan in today’s market place.
As you now know, commercial real estate investing is all about positive cash flow. You need to know how to make these and other calculations before making your first commercial investment. It’s always a good idea to obtain thorough commercial real estate training before making your first investment.
Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.