Five commercial real estate calculations that everyone should know (and free calculators!)
If you’ve ever been interested in commercial real estate, and particularly investing in real estate, there are some simple calculations that you should be aware of and understand in order to determine the financial health of a property or portfolio. As you incorporate these calculations into your investing strategy, you will be able to quickly pre-qualify potential opportunities to determine if they are viable for your pursuit. You will also be able to look at your existing assets to continuously ensure that they are still worth holding (or how to re-establish their value if necessary). Below I have outlined five such calculations, as well as links to their corresponding calculators (also found under the MARKET NEWS/CALCULATORS tab above).
1. Net Operating Income (NOI)
NOI = Real Estate Revenues - Operating Expenses
The Net Operating Income takes into account the gross income of an asset, the vacancy and structural loss, and the operating expenses, all before debt servicing and capital expenses. Operating expenses can include, but are not limited to, maintenance, repairs, accounting, legal, insurance, and property management. This is a very important number in valuation because it is utilized in many other formulas (as you’ll see below) to determine viability and profitability of an asset. It can also be viewed as the value remaining at the end of the day to pay your lender.
2. Capitalization Rate (Cap Rate)
Cap Rate = NOI / Purchase Price
The cap rate calculation can help to provide a simple valuation of a property (or compare properties) by telling you the rate of return if you bought an asset in cash, essentially removing debt service provisions as a variable. Cap rate data is collected constantly for the various commercial asset classes (industrial, retail, office, multi-family), but generally speaking, the riskier the asset, the higher the cap rate (or expected rate of return) a buyer will demand. Alternately, this equation can be modified to calculate the prospective value or NOI of an asset, depending on the variables you have access to. The following link will provide you with a free calculator to implement this formula to find the basic valuation for a commercial property:
3. Monthly or Annual Rent (Price per Square Foot)
Annual Rent = Price per Square Foot x Total Rentable Square Feet (/12 for Monthly Rent)
The price per square foot (PSF) is a commonly used metric in commercial real estate to allow tenants to value commercial lease spaces on an apples to apples basis. Each commercial space is a different size and has different offerings, so it’s important as a tenant to understand what the net rent is (PSF) and what the additional rent is (PSF) in order to fairly compare sites. As a tenant, if you are looking at an advertisement for a space, it will likely already be listed on a PSF basis. The following calculator linked below will help you to determine what your annual and monthly rent costs will be for each space, on a net and gross basis. Most commercial leases are triple net, meaning you will need to pay a Net PSF value to lease the space, as well as an Additional Rent PSF value to pay for your proportionate share of the operating costs (maintenance, property taxes, insurance, management fees, etc.).
4. Debt [Service] Coverage Ratio (DSCR or DCR)
Debt [Service] Coverage Ratio = NOI / Debt Service
This calculation is used primarily by lenders to determine the ability of a property to cover the debt that may be applied to it. Lenders generally like to see a DSCR of at least 1.2 - 1.25 meaning the property is generating enough income to cover the entire debt payment plus 20% - 25%. The additional cushion helps to protect the asset should there be any volatility in the market, affecting vacancy or rents. The following link will direct you to a commercial mortgage calculator to assist you in determining your monthly and annual debt service costs.
5. Cash on Cash Return
Cash on Cash Return = (NOI - Debt Service) / Cash Invested
This equation is another means to calculating the cash return you are making on the cash you have invested. You look at the annual Net Operating Income you are earning, deduct the Annual Debt Service payment (both of which can be computed through the linked calculators above), then divide this by the amount of cash (equity) you have invested into the transaction. This will tell you how much of a return you are making - shoot for at least 10% - and also, how long it will take you to cover your initial investment - i.e. 25% cash on cash return will only take 4 years to cover your investment; 10% will take 10 years.
If you are feeling inspired by this scintillating topic, there are many more commercial real estate calculations that can help you determine if a potential asset (or portfolio) is performing well and a good investment, such as:
Return on Equity (ROE)
Return on Investment (ROI)
Break-Even Ratio
Gross Rental Multiplier (GRM)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Let me know if you’d like further explanation, examples, or understanding of any of the above calculations, or others you come across in the financial and commercial real estate fields.
I hope you find the calculators useful in your future commercial real estate endeavors!