Finding the right CRE investment property to purchase can be a difficult decision. There are many factors that go into this decision making process and it can be overwhelming to buyers. The most important thing a buyer needs is determine the value of the property they are purchasing. This post is the first in a two-part series that will look at the 5 important things that buyers need to know in order to determine the value of an investment property. The first two, covered in this post, are “Know the Cap Rate” and “Know What the Cost of Taxes & Insurance on the Property WILL BE.” Keep an eye out for part two!
The capitalization rate, commonly referred to as the “cap rate”, is a percentage rate used by real estate investors and professionals to value income producing properties. The cap rate shows the potential rate of return of an investment property by taking the net operating income (annual gross income minus annual operating expenses) and dividing it by the market value or sales price of the property (NOI/Market Value = Cap Rate).
Alternatively, a buyer can use the market cap rate of similar properties to give the buyer the market value of a property based on the current net operating income (NOI) the property is producing. To determine this, the buyer would take the NOI of the property and divide by the appropriate cap rate (NOI/Cap Rate = Market Value). Knowing the appropriate cap rate for the property is a good start for a buyer in determining what the value of the CRE investment property is, and what price the buyer should be willing to pay for the property.
When a CRE investment property is listed for sale, sellers and their agents will provide you with an NOI for the property based on the current expenses, including taxes and insurance. What the seller is currently paying for taxes and insurance will, in almost all cases, be different than what the buyer will be paying for those items. The reason for this is that taxes will be reassessed once the buyer purchases the property and taxes will be based on the sales price the buyer paid for the property. This will, in most cases, cause the buyer’s future tax bill to be different than that of the current tax bill on the property.
Likewise, the insurance premium for the buyer will, in most cases, be different than sellers for a couple of reason. First, it is possible that the buyer will be getting the property insured at a different value/coverage amount than the seller. This could be due to the buyer paying more or less for the property than seller currently has the property insured for. Secondly, the buyer may be using a different insurance company that offers better or worse rates than the seller was getting. Sometimes sellers own multiple commercial properties and have insurance for all their properties packaged together at a discounted rate. If the buyer is not able to do the same, the buyer’s insurance premium will be much higher than what seller is paying.
Any increase cost in taxes or insurance will result in the buyer’s NOI being lower than the one given by the seller. This will in turn reduce the buyer’s rate of return on the property. Buyers should always do their due diligence on these two expense items and come up with a best estimate for each before determining what the value of the CRE investment property will be to them.
When making that all important decision to buy investment property, a buyer, most importantly, needs to know what the value of the property is. If a buyer will make sure to research and determine these two things (along with the three in my next blog post) before purchasing a property, it will help the buyer to make an accurate determination of value. This will ensure that the buyer will make a sound investment decision. If you need help determining the value of an asset, contact me today at [email protected].
About Joey – Joey Canella is a member of the SVN | Graham, Langlois & Legendre team in Baton Rouge, Louisiana. He has been in serving as a commercial real estate Advisor since obtaining his real estate license in 2008, prior to to that Joey practiced as a real estate attorney from 2006 to 2008, where he handled residential and commercial real estate transactions. Joey specializes in investment property sales as well as office sales and leasing. He currently serves on the Office Market Committee of the Baton Rouge TRENDS in Real Estate Conference. To contact Joey, you can call him at 225-367-1515 or you can email him at [email protected]. You can also follow him on Twitter at @svngll or on Facebook.