The following Q&A was completed as part of our conversational Commercial Real Estate FAQ Interview Series, we hope you find it helpful.
The common way to value multi-family commercial properties isn’t always the best way to value them. While the measurement of cap rate is a simple thing, it can often by simplistic and mis-applied. Using the returns the property is going to generate is another way to value these properties using the internal return and the cash on cash return together.
Richard Wilson: My first question here – how are multi-family commercial properties valued?
Brian Burke: Well, there’s a couple answers to this question, Richard, and you know there’s a right way to do it and there’s the way a lot of people think it’s done. The common held belief is that real estate is valued using a measurement called the cap rate. Cap rate is simple where you take the income, the net operating income, of the property, you divide it by this so-called cap rate, and you arrive at the value. It’s a very over simplistic approach and often very misunderstood and mis-applied. The way we value commercial properties is we value it using the returns the property is going to generate. So we use the internal return and the cash on cash return. So what you basically have to do is you map out the income of the property over a specified hold period, you factor in how much your debt is going to cost you and how much equity you need to bring to the deal, and then you can calculate the internal rate of return. The value of the property is going to be that price, which gives you the internal rate of return that meets your investment objectives, which is why income real estate is worth a different price to different investors, right?
Richard: Right. For sure, makes sense.