Wednesday, October 12, 2011

Understanding Commercial Properties

In commercial real estate, properties are ranked in terms of age and location as "A," "B," "C," or "D" properties.

"A" properties are the highest end, luxury properties, built in the last 10-15 years and in prime urban locations.

"B" properties are in mixed blue collar/white collar neighborhoods, and built 10-20 years ago.

"C" properties are in primarily blue collar neighborhoods, and built 20-30 years ago.

"D" properties are in more marginal or war zones, more than 30 years old and typically functionally obsolete. They generally need a good deal of work to rehab or upgrade.

Capitalization (Cap) rates typically increase from A to D properties, with A properties having the lowest cap rates and D properties the highest. Cap rates are a measure of risk.

The formula for determining Cap Rate is
Net Operating Income(NOI) divided by Purchase Price = Cap Rate

Net Operating Income is determined by subtracting all expenses other than financing costs (debt service) from Gross Annual Income, which is all revenue generated by the commercial property.

Debt service, or the financing in place on a commercial property, comes into play when calculating Cash-on-Cash Return. The formula for Cash-on-Cash Return is

(NOI minus Debt Service) divided by Acquisition Costs.

Acquisition Costs are all the money put down to purchase a property, including down payment, closing costs and acquisition fees. According to Dave Lindahl, multifamily acquisitions guru, the amount of acquisition costs an investor is willing to pay towards a commercial property will depend on the specific phase of that particular market cycle.

In a Buyer's Market One or a Seller's Market One, an investor might put down up to 15% in Acquisition Costs. In a Buyer's Market Two, with more negotiating power, an investor may be able to put down as little as 10% in Acquisition Costs. But in a Seller's Market Two, an investor might have to go as high as 20% in Acquisition Costs to acquire a good commercial deal.

Certainly, buyers will pay more for commercial properties, but Lindahl is a proponent of putting down as little money as possible. This will actually increase the Cash-on-Cash Return for an investor, which Lindahl likes to see at 12 percent or higher.

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