Do you know how to spot the profit potential of a commercial property?
If not, today is your lucky day…
Because right now, I’m going to reveal the main financial yardsticks investors apply when sizing up a potential purchase.
Even better, I’m going to walk you through them STEP-BY-STEP.
But before I do, bear in mind that metrics can only give you a PARTIAL view of a property’s ability to make a profit.
In other words, you also need to consider a zillion other factors:
Like the quality of a property’s tenants, the length of the leases, how much tenant demand there is for your kind of property, your building’s structural soundness, what the future holds for your street, planning regulations, what’s happening in the local, national and international economies, etc, etc, etc….
But without applying the following yardsticks, you won’t have the numbers you need to have an informed view about a property’s profit-making potential.
So, what are these yardsticks?
Here’s the list:
• Gross operating income.
• Gross yield.
• Operating expenses.
• Net operating income.
• Net yield (also known as capitalization rate).
• Price per square foot.
If your eyes are starting to glaze, bear with me because these metrics are ANYTHING but dull.
Even better, they’re a doddle to understand…
1. Gross operating income
The ultimate purpose of a commercial property is to generate an operating profit for the owner.
I kid you not ☺
But before your property can make an operating profit, it must obviously generate revenue.
That’s why your first step when working out a property’s value is to find out how much revenue it’s bringing in from rents – and from all other forms of income (e.g. car parking fees, fees for hosting outdoor advertising billboards, etc).
This income from day-to-day operations is called ‘gross operating income’.
And when people talk about it, they typically refer to the annual figure.
Here’s a simple example of gross operating income…
Let’s say you own a retail unit.
And the sole income from that unit is $50,000 in annual rent.
In that scenario, your gross operating income is $50,000.
What you can learn from gross operating income
Once you know a property’s gross operating income, you’re in a position to do a number of interesting things.
For a start, you can work out how much gross operating income is being generated per square foot (or square meter).
For example, if the retail unit generating $50,000 is 1000 square feet in size, the gross operating income per square foot is $50.
That gives you a yardstick with which you can compare the property’s performance with other properties.
Why would you do that?
For a start, if you look at comparable buildings in the same area, you can see whether your property’s rents per square foot are in line with the rest of the market.
When you make that comparison, you’ll see whether your rents are lower than they should be, higher than they should be or about right.
Knowing how a property’s rents compare with the market is vital when trying to figure out how much money a commercial property can make.
For example, if the rents are higher than the market rate, it’s possible they will drop next time they’re negotiated.
And if they drop, it’s likely the value of the property will fall, too.
Likewise, if the rents are below market rates, its possible you could increase them – probably boosting your building’s value in the process.
That leads to another benefit of wrapping your head around a property’s gross operating income:
Judging its potential gross operating income.
Potential gross operating income
When you’re thinking about buying a commercial property, it’s vital you estimate how much gross operating income it has the potential to generate in the future.
This is ultimately an educated guess based on where you think rents are heading.
To do that, you need to become an authority on what’s happening in the area where your property is located.
In particular, you need to get a feel for what kind of tenants are moving in. And what kinds are moving out.
That will give you a sense of what kinds of accommodation will be in demand.
Meanwhile, you also need to get a grip on the mega trends shaping how people live, work and play.
For example, e-commerce has obviously wiped out vast numbers of bricks and mortar retailers.
Great swathes of once-valuable retail space is now close to worthless – especially in poorer areas with low footfall.
In contrast, you’ll have noticed that the centres of our prosperous cities have seen a boom in coffee shops. Retail units that appeal to tenants like Starbucks are in hot demand.
The better you understand these trends, the more accurate you’ll be in figuring out a property’s potential gross operating income.
In turn, that will obviously allow you to better guestimate the future value of that property.
2. Gross yield
When you invest money in a commercial property, you’ll want to know how much it pays back to you each year.
The simplest way to measure this is to compare the purchase price with the gross operating income.
That tells you your ‘gross yield’.
Just like the interest you get on your savings in a bank account, your gross yield is expressed as a percentage.
For example, imagine you purchased a property for $1 million.
If the building’s gross operating income is $100,000, your gross yield would be 10%.
If the same building generates $50,000 of gross income, your gross yield would be 5%.
Spending a few seconds to figure out the gross yield is a great way to get a general feel for how profitable a given property might be.
But gross yield only gives you a back-of-the-envelope feel for what’s going on.
I’ll show you a more accurate tool shortly (called ‘net operating income’).
But first, let’s talk about future gross yield…
Future gross yield
Once you know how much gross yield a property is generating today, it’s crucial that you guestimate how much gross yield it might generate in the future.
Because yields on commercial property tend to move up and down over time.
On that note, there are a number of forces at work that can shift your yield one way or the other.
For a start, there’s the general health of the economy. When the economy is booming, investor demand for commercial property generally rises.
That typically causes purchase prices to go up faster than rents.
In turn, that obviously results in yields falling.
For example, imagine a retail unit generating $50,000 in gross operating income was purchased during an economic downturn for $500,000.
Obviously it was bought on a 10% gross yield.
Fast-forward a few years to a period in which the economy is booming.
At this point, the property is sold for $1 million – even though it still generates $50,000 in rent.
At that point, the gross yield has dropped to 5%.
This process is called ‘yield compression’.
Yield compression explained
Yield compression is something commercial property owners DREAM of.
Because as my example shows, a seemingly small amount of yield compression results in a big lift in your property’s value.
So what drives yields up and down?
Ultimately, it reflects the level of investor demand for property in a given area at a given time.
For example, yields tend to rise during recessions (when there are typically fewer buyers around).
Meanwhile, regardless of the economic cycle, yields tend to be lower in more prosperous neighbourhoods (because more investors are drawn to affluent areas thanks to the fact that those areas typically attract a greater number of quality tenants).
How to compress your yield
If you’re an active investor, you obviously want to benefit from yield compression.
A typical strategy [link to Boston Properties guy] is to buy your property during an economic downturn.
With fewer buyers in the market, it’s likely that you’ll be able to buy at a lower price – and a higher yield.
Secondly, consider buying property in up-and-coming neighbourhoods.
As an area’s economy improves, so too might the value of your building.
And importantly, there’s a reasonable chance it will do so at a faster rate than existing wealthy areas.
Thirdly, attract quality tenants.
In other words, tenants with a track record of paying their rents on time over many years.
And who are likely to remain in business for years to come.
Fourthly, get those tenants onto long leases in order to secure your income stream as far into the future as possible.
Then ideally sell your property during an economic boom.
3. Operating expenses
Like gross operating income, these are usually described in annual terms. In other words, how much is being spent per year.
Common operating expenses include:
• Monthly management fees paid to your property manager.
• Estate agent fees (e.g. every time an agent sources a new tenant, you’ll pay them a fee).
• Building insurance (you’ll be liable to cover the building insurance for units that are vacant)
• Legal fees (e.g. every time you agree a new lease with a tenant, you’ll have to pay a solicitor to draw up the lease).
• Repairs and maintenance.
• Utility bills (e.g. electricity for common parts of the building).
• Rates and taxes (e.g. in many jurisdictions, the landlord must pay the rates on vacant units).
Once you’ve figured out your operating expenses, you can then deduct them from your gross operating income.
That leaves you with the all-important ‘net operating income’ (NOI).
4. Net operating income
If your property’s gross operating income is $100,000 but operating expenses are $25,000, your NOI would be $75,000.
Establishing your NOI is obviously easy when you own the property in question.
But it’s harder when you’re evaluating a property you’re thinking of buying.
After all, while vendors will typically supply you with information about how much income their property is generating, they may not be so forthcoming with information about operating expenses.
There may be a variety of reasons for this. A common one is that the vendor – especially if they’re a small-scale landlord – may not have an accurate record of all their expenses.
If you can’t get your hands on the property’s expense information, find a property manager who looks after similar buildings to provide you with a guesstimate.
5. Net yield (capitalization rate)
Earlier I explained the concept of gross yield – how much the gross operating income represents as a percentage of a property’s purchase price.
That’s a useful metric when you want a quick back-of-the-envelop way to value a property (and compare it to other properties).
But a more accurate metric is the ‘net yield’.
This is also known as the capitalisation rate (‘cap rate’ for short).
Unlike the gross yield, the net yield compares the net operating income to the property’s purchase price.
In other words, it shows you how much actual profit your property generates – expressed as a percentage.
When you can work out your net yield, you can see a number of critical things.
For a start, you can judge what your return would be if you bought a given property at a specific price.
And you can see how that stacks up against alternative investment opportunities.
Like buying a different property.
Or buying shares.
Or simply leaving your money in the bank.
In general, positive cash flow is VITAL if a commercial property investment is to succeed.
That said, a property that needs investment to maximise rents may not be cash-flow positive in the years when it is being upgraded.
Once your property is cash flow positive, all your outgoings can be covered – there is no need for you to dig into your pockets to cover anything.
It’s for that reason that banks are especially focused on whether a property is cash flow positive before they’ll agree to lend against it.
So how do you calculate a property’s cash-flow position?
Simply take your NOI – then deduct any loan repayments (interest and principal).
In other words, it’s the cash you actually receive – before tax.
This pre-tax cash flow is called Cash Flow Before Taxes (CFBT).
It avoids factoring in taxes as these will vary from landlord to landlord.
Instead, CFBT simply looks at how much cash the property is throwing off – regardless of who owns it.
The ‘cash-on-cash’ metric tells you what the annual return is on the money you’ve personally invested in a property (as distinct from any borrowed money you’ve used to buy it).
In other words, if your property cost $1 million, and $300,000 of that was your own money, cash-on-cash shows you the annual return on your $300,000.
That’s in contrast to the net yield metric, which shows you the annual cash return on the full $1 million.
Let me explain with an example.
Let’s say you buy a $1 million property.
You fund 100% of the purchase with your own money.
Now, assume your property is generating a NOI of $100,000.
That’s a net yield of 10%.
And a cash-on-cash return of 10%.
But what if you used a loan to help buy the same property at the same $1 million price tag?
It turns out the return on your own money – your equity – goes UP.
As an example, let’s assume you’ve used your own cash to fund 50% of the purchase price.
And you’ve borrowed the other half.
In that scenario, you’re enjoying the same $100,000 of NOI – but you’ve only had to kick-in $500,000 to get it.
That means you’ve doubled your cash-on-cash return to 20%.
As a third example, what would happen if you only contributed $250,000 of your own money to the purchase?
Your cash-on-cash return would be 40%.
Strengths of cash-on-cash analysis
Cash-on-cash analysis is a great way of understanding the attractiveness of a given investment idea.
For example, if you want your property to provide you with a positive cash flow, it will give you a sense of how much cash you can expect.
Meanwhile, for any investor, cash-on-cash analysis obviously shows how borrowing money to fund a property purchase might affect their return on equity.
Draw-backs of cash-on-cash analysis
As with all the metrics I’m introducing you to today, cash-on-cash doesn’t tell you the whole story about a property’s financials.
For example, it doesn’t tell you how much cash you’d receive post-tax – an amount that will obviously vary depending on things like your tax arrangements, how much you borrow, etc.
Nor does it account for any increase in the capital value of your property.
8. Price per square foot (or per square meter)
Although I touched on this earlier, I want to explain this to you in more detail.
That’s because if you wish to be a player in the commercial property market, you MUST wrap your head around this yardstick.
Because it allows you to compare the price performance of different properties.
In particular, you can compare the valuation of one property with another – even if they feature different sizes, layouts or planning approvals.
Meanwhile, you can compare how much rent different properties are generating – which is especially useful when you’re comparing the performance of similar properties in the same neighbourhood.
Let me explain…
Comparing the valuation of different properties
By finding out what buyers are paying per square foot in your neighbourhood, you can build up a picture of what your property is likely to be worth.
For example, if buildings similar to yours on the same street are selling for $5000 per square foot, it’s likely that yours would attract a similar price.
When comparing the purchase price of different properties, you should ideally find out what the price per square foot is of the following:
• Gross Internal Area (GIA) [LINK].
• Net Internal Area (NIA) [LINK].
• Land area.
Next, make sure that when you compare properties, you’re comparing the GIA of one property with the GIA of another.
Or NIA with NIA.
Or land area with land area.
Don’t make the mistake of comparing the GIA of one building with the NIA of another – because you’ll end up comparing apples with oranges.
As you know, the value of a commercial property is largely based on how much rent it generates.
By looking at how much rent your tenants pay per square foot, you can see where your property stands relative to the rest of the market.
For example, are your rents per square foot lower than in other similar buildings? In other words, is your property under-rented [LINK]?
If so, there may be scope for you to raise them – thereby potentially boosting both your net operating income AND the value of your building.
Conversely, are your rents higher per square foot than in other similar properties? In other words, is your property over-rented [LINK]?
If so, it’s possible that rents in your property are set to fall – thereby potentially reducing your net operating income and your property’s value.
You can also use rent per square foot to compare DIFFERENT kinds of buildings.
For example, if you own a Class B office, you can compare how much rent it attracts against a Class A office in the same neighbourhood.
Why would you want to know that?
Because it allows you to figure out whether it would be worth investing in an upgrade of your office to Class A office space.
Meanwhile, you can use rents per square foot to see the impact of different planning approvals.
For example, you may find that where office spaces similar to yours have been granted approval to host educational tenants (e.g. language schools), they command higher rent.
How do you find out what rents are being charged in your area?
One way is to check out the listings for properties that are being sold. These usually spell out how much rent each tenant is paying – and how much floor space they’re occupying.
Alternatively, talk to local estate agents.
And remember: when comparing rents, make sure you’re comparing NIA with NIA.
And GIA with GIA.
You now know the main yardsticks for measuring the finances of a commercial property.
But how do you use them in the real world?
The main thing to remember is that no single metric – or combination of metrics – will give you a COMPLETE picture of what’s going on.
You obviously need to use them in conjunction with loads of other information like the nature of the leases in a specific property, the quality of the tenants, the structural integrity of the property, how the neighbourhood is developing, etc, etc, etc.
Only when you have all those pieces of the puzzle can you start to make informed decisions about how to proceed.
Now that you’ve read this article, I want you to do TWO things:
Thing #1. In the comments section, let me know if you have a question about any of these techniques. Or, if you have any experience of using them, tell me how they’ve worked out for you.
Thing #2. Do you know anyone who would benefit from understanding these metrics? If so, send them a link to this page – they’ll be glad you did. While you’re at it, please show me you found this info useful by sharing it via Facebook, Twitter, etc – simply click one of the ‘Shares’ icons on this page.