One of the most difficult decisions that commercial investors must make is determining the value of a specific property. This varies greatly depending on the use or potential use of a property and other variables. The income generated by the property is the most important factor. One most often used method is the capitalization rate. This is an indirect method for determining how long a property will take to pay for itself.
By taking the cap rate formula one step further, you can easily determine how many years before the property pays for itself. This is the Earnings Multiple.
Let's begin with a brief review of the cap rate formula. It's net operating income divided by the cost of the property. A $500,000 property producing $100,000 in net operating income has a cap rate of 20%.
Once you have the cap rate, calculating the earnings multiple is as simple as 1/cap rate. For our example, it is 1/.20 = 5. This tells you that net income from the business pays for the property in 5 years.
There is no firm earnings multiple that you can use as a rule of thumb. However, earnings multiples in the range of 2 to 5 years are desirable.
Why Commercial Property is Highly Profitable
The earnings multiple is similar to the price to earnings ratio used to evaluate common stock. The reason I bring this up is to explain the complexity of determining an acceptable earnings multiple for commercial property. Acceptable P/E ratios for healthy publically traded companies typically range from 12 to 20. Substantially higher than the acceptable range for commercial property.
The reason is that owning a small business is perceived as being riskier than investing in stock of a publically traded company. Hence, owning commercial property is better rewarded. The risk/reward calculation is further refined across the different commercial real estate sectors.
Both the hotel and office sectors continue to struggle with high vacancy rates and therefore income is down. Of course, this means more risk to an investor. Rewarding that risk means an earnings multiple of 2 or 3 is appropriate. On the other hand, apartment vacancy rates are way down and rents are on the rise. Much less risk. This translates into a higher earnings multiple of at least 5.
There are several variations to calculating the earnings multiple. Most commonly is using net operating income (NOI) from the previous year. Another version is using the average NOI from the past 5 years. Or forecasting NOI for the next several years.
Also, the example doesn't take into consideration any loans used to finance the property. Interest expense is typically exclude from the calculation to accurately reflect the actual cash you have invested in the property and hence how many years it takes you to recover your actual investment.
Other Valuation Calculations
The earnings multiple is only one indicator of a commercial property's value. Other valuation methods are:
Asset valuation - This adds up all of the property assets and subtracts liabilities. It tells you what the property is worth when sold without considering future income.
Capitalized future earnings - This method estimates the future return on investment. It's a good measure for comparing to other investment opportunities (i.e. stocks and bonds).
Comparable sales - This is a comparison to the sales of other similar businesses in the same local area based on square footage and amenities. There are a lot of other variables that need to be considered other than only square footage, age, amenities, and condition of the property.
When it comes to valuing commercial property, the income generated is the most important number to consider. Calculating the earnings multiple is a good place to start.
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.