How Pricing is Determined: Commercial vs. Residential

The value of commercial real estate is determined in a very different manner than residential property.

In residential real estate, the listing price is determined by the seller and the real estate agent based on the physical characteristics and location of the property. Comparable sales are analyzed for a myriad of variables including price per square foot, number of bedrooms, bathrooms, and garages. In addition, features like a pool or central vacuum and location such as a cul de sac, corner, busy street, or view lot are important to pricing.

Adjustments are made in the suggested price, in an effort to make it equal to the comparable properties. For instance, if the subject property has one more bedroom and 500 more square feet of living space than the comparable properties, the listing price will be increased by an appropriate amount.

In commercial real estate, pricing is driven by the income the property produces. Although physical features are important factors that buyers consider, they are considered primarily to the extent that they enable the property to command higher rent or decrease its operating expenses. Location is also considered to the extent of the ability of the property to command higher rents and appreciate. It is the amount of cash flow and what an investor is willing to pay for these cash flows that will determine the price of the property.

The measure of income the property produces is called Net Operating Income (NOI). It is simply the income generated from operations less the expenses incurred during the operations.

Operating Income
Less
Operating Expenses
Equals
Net Operating Income

Put simply, if the annual NOI from a particular property is $100,000 and an investor is willing to pay $2,000,000 for that NOI, then the property is worth $2,000,000 to that investor. If another investor is only willing to pay $1,000,000 for that NOI, then the property is worth $1,000,000 to that investor.

Investors will consider numerous properties in a given area to determine the standard of how much must be paid for NOI. The "going rate" in area can be considered its Capitalization Rate (Cap Rate), which is simply a percentage rate. While an exact definition and explanation will be detailed in a subsequent article, here is the formula:

Net Operating Income
Divided By
Property Price
Equals
Cap Rate

In this example, the first investor only required a 5% return on investment and was therefore willing to pay $2,000,000 for $100,000 of NOI. The second investor required a 10% return and was therefore only willing to pay $1,000,000 for the same $100,000 of NOI.

This one year return, in commercial lingo sounds like the second investor requires a "10 Cap" and that the first investor only required a "5 Cap". This is a simplified explanation but you get the gist.

How do investors determine whether they need a 5% return or a 10% return? Commercial investors make that determination based largely on their opportunity costs.

Opportunity costs are the costs associated with not having money invested at all or having it invested in the wrong investment. For instance, if an investor could alternatively invest in a stock, bond, T-bill CD, or other instrument and yield 10% on that same investment, why would he/she buy a property which only yields 5%? In order to attract this investor to the property owner would have to lower the price to give that investor a 10% return or wait until an investor comes along who finds the 5% return attractive, based on other opportunities presented to them.

Notice the inverse relationship here. As prices are lowered, the return to the investor or Cap Rate goes up. Conversely, as prices are increased the return to the investor or Cap Rate down.

Cap Rate only takes into account the first year of cash flow and does not account for the second year, third year, etc. Notice I have not even mentioned appreciation. Commercial real estate is primarily considered based on its cash flows while investing in residential real estate is almost totally based on appreciation.

In residential, there is only one way to win. Prices people are willing to pay for houses to live in must go up! In commercial real estate investors are purchasing cash flows. In our example, if the investors paid all cash, they would have been paid back 100% of their initial investment after 10 years and as of the 11th year, they would have $100,000 of annual cash flow from that single property.

Hopefully the property will have appreciated as well and the market will be favorable. But at the very worst case if no appreciation occurred whatsoever, the investor would still enjoy the $100,000 of annual cash flows.

Most investors do not pay all cash for a property but use financing to help them buy the property. This is called using leverage. When you use leverage you can make the mortgage payments with your NOI.

Net Operating Income
Less
Debt Service
Equals
Cash Flow Before Tax

Consider this. Let’s say that the first investor leveraged the property and only put down a 10% deposit or $100,000 to purchase the $1,000,000 property. This amount would be the investor’s Initial Investment. Let’s also consider that the remaining $900,000 was financed at 7% for 25 years which is typical in commercial financing.

With a fully amortizing loan (meaning principal is paid down as well as interest paid), the annual payments would be $63,000. This is called debt service.

The debt service is paid from the $100,000 NOI produced by the property, leaving $36,000 of Cash Flow before Tax. For simplicity sake, I will not account for tax effects on income or yields.

In this case, in Year 1, the investor has earned $36,000 for a $100,000 cash outlay, or a 36% Cash on Cash return. The way to figure a Cash on Cash return is to divide the Cash Flow before Taxes by the Initial Investment.

Cash Flow Before Tax
Divided By
Initial Investment
Equals
Cash On Cash Return

Assuming no change in the NOI, the investor would receive this same amount for 25 years until the debt is paid off. Subsequently, all other things remaining equal, the investor will enjoy the entire $100,000 of NOI.

Notice again, I haven’t even spoken about appreciation which may or may not occur. But even if no appreciation occurs to our example property, this is still an incredible investment!

Now obviously during a 25 year period these cash flows will change as rents will be increased and capital improvements will likely be needed (new roof, etc). But again, I’m keeping it simple for example purposes.

To summarize: In residential real estate there is only one way to win. The strategy is to carry the property and hope that the market goes up and that the property appreciates so that the investor can sell for more money than was paid. Positive cash flows are typically non-existent and if present, negligible relative to the anticipated appreciation the residential investment will bring.

In commercial real estate it’s the other way around. Properties are purchased for their positive cash flows with potential appreciation a secondary consideration.

And, it is for this reason that commercial real estate is more stable and can weather financial storms that residential investments cannot.