When we go back to critical thinking, we have to consider what the property is. Is it a retail building, a motel, a hotel or a stadium? What is it and what does that mean? What is it worth? To who? What is their risk preference? What is their opportunity cost? By setting our discount rate and asking these questions, the total implication on value can be calculated, where the implication on value, very easily, is the series of cash flows that you apply your required rate of return to, to get back to the value today.
A pro forma valuation is basically taking a series of future cash flows, or a single lump sum of future cashflow, applying a discount rate of return to it to arrive back to the present value or the value of the property. What is it? Why? To whom? What is the implication of value? Therefore, what is the value? That’s it. That is the process of critical thinking to evaluate a property.
Once you do that, you can go into the critical thinking of how to design it, whether you need a permit it and how easy that will be for this property. You may need to lease it, ok well how easy is that going to be? Maybe you have to build up a skyscraper, well, how much is that going to cost? How easy or risky is that? There are all of these factors playing into the risk component of setting your return, together with the time value of money and together with the opportunity costs. Those three components always go into setting your discount rate of return.
That is how simple it is to value something. To continue with the theme of simplicity, let me share now how there are always two ways to evaluate commercial real estate.
- The dollar value in total dollars or per square foot
- The yield or rate of return, most commonly the Cap Rate
If a building is worth $10 million today, the other way to describe the value is based on the discount rate of return, that the property is worth a 5% Cap Rate. The Cap Rate equates to:
The recurring Annual Net Operating Income
The dollar Property Value.
= Cap Rate
Annual Net Operating Income over value is the capitalization, but really those are two ways of saying the same thing. This is because they validate each other.
A building may sound expensive if its $10 million… but why is it $10 million? Well, it may be that it generates a 5% per cent annual return on value, meaning if you buy it for $10 million today, you will earn 5% annually on an all cash basis. If we go back to what that cap rate is based on opportunity costs – buying this building and earning 5% versus buying a bond online – what is the better deal? Where else could you be getting a 5% capital rate of return and would it be easier or harder to do? Is it riskier to do 5% here versus going elsewhere to get 5%?
The beauty of commercial real estate is that you always have two ways to say the value of something. We have the dollar value of $10 million and we have the cap rate of 5%. Value is, of course, subjective. Who’s buying the property? Is it somebody who is rich that doesn’t need to put a loan on it?
Read the next article for an example of how a property may be valued differently by two people…