Whether you are a commercial real estate owner, investor, broker, manager, or lender, there are several indicators used throughout the industry when determining a property’s current or future performance. Depending on which commercial real estate hat you are wearing, some may be more important than others, but in any capacity, if you are or plan to be involved in commercial real estate, here are a few indicators you should know about:
Perhaps the most important indicator in commercial real estate is the capitalization rate, or “cap rate”. A cap rate is the yield or return an investor would expect to receive on an all-cash purchase of a commercial real estate asset before incurring costs such as capital improvements to the asset and/or debt service. The cap rate for an asset is simply the Net Operating Income divided by the Purchase Price. In the event of a commercial real estate sale, cap rates reflect the asset’s year-one performance compared to the asking price, and there are several factors to consider when determining cap rates. Some factors would include product type, location, tenant credit, lease term(s), and lease rate(s). The lower the cap rate, the higher the price, and vice versa. For example, a brand-new retail building leased by Starbucks will likely trade for a lower cap rate than a 1980s office building with a dozen tenants. Cap Rates are typically only used in the initial acquisition and later disposition of commercial real estate.
Cash-on-Cash Return – Leveraged vs Unleveraged
Unleveraged Cash on Cash Return is the annual return an investor can expect to receive on an all-cash acquisition of a property. To calculate the unleveraged cash on cash return for a property, take the property’s annual cash flow divided by the acquisition price. Unleveraged cash-on-cash returns typically go hand in hand with cap rates unless a capital cost (building or tenant improvements, commissions, capital expenses, etc.) is incurred, which will obviously drop the cash-on-cash return for that year. Similarly, the Leveraged Cash-on-Cash Return is the annual return an investor can expect to receive on a leveraged (debt) acquisition of a property. The Leveraged Cash-on-Cash Return is obtained by taking the property’s annual cash flow after debt service divided by the equity the investor has in the property. Cash-on-Cash Returns, either leveraged or unleveraged, are used to evaluate the annual performance of the asset during the hold period, not to be confused with the Internal Rate of Return, or IRR.
Internal Rate of Return – All Cash and Leveraged
The Internal Rate of Return measures the return an investor receives or may receive over the entire hold period of the asset. This can be measured in both all cash and leveraged acquisitions but unfortunately is not as simple as whipping out the calculator on your phone. The easiest way to calculate an asset’s IRR is to use the “=IRR” function in Microsoft Excel. An asset’s IRR cannot be calculated unless there is an initial acquisition and a future disposition. Annual cash flow during the hold period is also considered within the IRR calculation.
The first question any investor will ask when presented with an investment opportunity is “what will my return be”, but the second question is typically “if I invest X amount of dollars, how many dollars will I get out of the investment when it’s all said and done?”. That is what the equity multiple measures. Typically only used by investors, the equity multiple is determined by dividing the total equity distributed upon the disposition of an asset by the original amount of equity placed in the asset at acquisition. Put simply, the higher the equity multiple, the greater return to the investor. An equity multiple of less than 1.00X signifies a negative return to the investor.
Debt Service Coverage Ratio
A debt service coverage ratio, or “DSCR”, is a key metric used by lenders to determine a borrower’s ability to cover or pay back its debt service. In commercial real estate, an asset’s DSCR is obtained by taking the Net Operating Income divided by the annual debt service. The main function of the DSCR is to measure whether the asset is producing enough income to pay the mortgage. Most commercial lenders will require a minimum DSCR of 1.30X, which will typically be tested annually during the loan term or holding period. If the DSCR for an asset drops below 1.00X, the annual debt service is greater than the Net Operating Income the asset is producing, which is not something lenders like to see.
Let’s say an investor acquired Collin’s Supermarket back in 2018. The asset was leased by a single tenant with four years remaining on a triple net lease paying $250,000 in annual base rent, which increased by 5.00% annually. In the example cash flow analysis below, you can see that this investor acquired Collin’s Supermarket for $5,000,000 which equates to a 5.00% cap rate based on the year one Net Operating Income of $250,000.
This investor took out a loan of 50% of the acquisition price on the property at an interest rate of 4.00% based on a 25-year amortization schedule. This produced an annual debt service obligation of $158,351. Based on the existing lease in place, this investor was easily able to obtain this loan because Collin’s Supermarket produced an initial DSCR of 1.58X, well above the lender’s minimum requirement of 1.30X. The investment was also able to maintain a satisfactory DSCR over the entire hold period.
Through the first three years of the hold period, this asset provided an annual leveraged cash-on-cash return to the investor of 3.65%, 4.15%, and 4.67%, respectively. In the fourth year of the hold period, Collin’s Supermarket triple net lease expired, and this investor was able to renew the tenant at continued 5.00% annual increase to Base Rent. The cost to renew Collin’s Supermarket however totaled $150,000 (tenant improvements and leasing commissions). This caused the investors leveraged cash on cash return for that year to be negative 0.75%, as the cash flow after debt service was “in the red”.
During the fifth year of the hold period, the investor decided to sell Collin’s Supermarket. Using the 2023 Net Operating Income of $319,070, the owner sold the asset at a 6.00% cap rate, or $5,317,840. Upon the closing of the asset, it was determined the investor made a Leveraged IRR of 7.79% and an Equity Multiple of 1.42X.
These are just a few of the indicators to be aware of when investing in commercial real estate. The professionals at NavPoint Real Estate Group would be happy to provide a complimentary evaluation of your asset, feel free to reach out today!