If you’re looking to invest in commercial property there are some quick sums you need to work out what the value of a property should be, and what the income from it will be. This can give you a quick indication of whether this is a property that you want to do more research on or not, and save you wasting a lot of time doing detailed research on a property that doesn’t meet your requirements. This is the first article of our Commercial Property Investment Guide which aims to give you the tools to understand commercial property investment, how it differs from residential investment and how to get a commercial property loan.
Net Operating Income
With residential investment properties we look at Gross Rent, which is the rent received for the property, and Net Rent, which is the gross rent minus the property expenses. With commercial property there can be other sources of income than just the rent so they are generally called Gross Income and Net Income.
Gross Income is the total income from the property. This is primarily rent but can also include income from parking, signage on the property, vending machines, etc.
Net Income (or Net Operating Income, NOI) is the gross income minus all the operating expenses. The operating expenses can include property management fees, insurance, rates, land tax, repairs and maintenance and other miscellaneous expenses such as legal and accounting. So the net operating income is an indicator of the property and what income it can produce.
The NOI is positive when the income is greater than the costs and negative when operating expenses are greater than the income. It can be calculated using historical financial data, like the most recent tax year financials, or estimates for future years, particularly if you are looking at doing renovations or building works that will increase the income from the property.
Mortgage Payments and Cash Flow
You probably noticed that mortgage payments are not included as an operating expense. This is because it is calculated as though you have no loan on the property. The Net Income figure is only concerned with the income and expenses of the property, not your finance arrangements. You will have different finance arrangements depending on the property you select, so Net Income allows you to compare properties quickly as part of your initial research without considering the finance.
If we want to assess the property for a particular investor and take the mortgage payments into account, then we would measure the Cash Flow:
Net Income (per annum) – Mortgage Payment (per annum) = Cash Flow (per annum)
So if the property has a Net Income of $7,500 per annum and the mortgage repayments are $6,000, then the cash flow is $1,500 per annum.
Yield or Capitalisation Rate (Cap Rate)
Now we know what the Net Income is, we want to get on to calculating the yield for our commercial property because this is one of the main indicators used by commercial property purchasers. There are two types of yield: gross yield and net yield. Just as with the income we discussed above, gross yield looks at the income but ignores the expenses. So the figure we are really concerned with is the Net Yield because this tells us what is left from the income once the costs are taken out.
Gross yield looks at everything except expenses while Net Yield takes into account all the running expenses such as the management fees, rates, vacancy costs, building insurance, land tax, strata levies, stamp duty, legal costs, repairs and maintenance.
A lot of commercial leases pass some of the expenses, such as council taxes, water rates, insurance costs and management fees on to the tenant. If they are paid by the tenant then you can leave them out of the Net Yield calculations.
The Net Yield does not include loan repayments, taxation or depreciation because these are all things that are determined based on the purchasers financials. The Net Yield or Cap Rate is based solely on the property and can thus be used by any potential purchaser to compare the figures of that property with any other that they are looking at. It is a figure that many Real Estate Agents will be able to tell you for the property they are selling, and you can also get an indication of yield from other similar properties in the same area. An approximate figure can also be obtained from, www.savills.com.au under their Research tab which gives average yield for different types of commercial properties in our major cities and in outlying areas.
Calculating Yield (Cap Rate)
The net yield is calculated by dividing the net operating income by the current market value.
Net Yield = net operating income/ property value x 100
This will give you the Net Yield as a percentage.
The net operating income (NOI) is found on the seller’s income and cash flow statements for the property. If possible look at the NOI for the last 3 years so you can use an average value.
I mentioned before that the NOI includes vacancy costs. These are a variable cost because if you buy a vacant property it may take some time to find a tenant, while if you have a tenant on a 3 year lease there will be no vacancy cost. You just need to realise that it is worth looking at the figures that have been used in calculating the NOI (such as did they include any vacancy?) to make sure that they are realistic for your circumstances so you don’t get any surprises down the track!
So the yield shows you what you could achieve in return but you have to remember that if you cannot find and keep a tenant, if the location and style of the property is not ideal or if you have high maintenance costs, the actual yield can be quite different.
The yield for commercial property can be 7% and greater compared to yields of 4-5% for residential property, and this is part of the attraction of commercial property investment for many people.
The yields in commercial property are affected by market conditions (the economy, politics and consumer confidence) more than residential property because people will always need a place to live, but businesses can go out of business.
When demand for properties is high, the more you pay to purchase the property and the lower the yield. When property is in low demand, prices are lower and yields can increase (assuming the rent stays the same).
Calculating Property Value
You can also use this equation to work out the market value of the property if you know the net income. On some property ads they list the net income rather than the property price and using the equation this way you can work out roughly what the value of the property should be. If you talk to a local real estate agent, check the ‘for sale’ ads for similar properties or even visit the Research page of www.savills.com.au you can get a value for the yield (I go into more detail on this in Example 5, below). We can then rearrange the equation so that:
Market value = net operating income / yield
Example: So you are looking at a property that has a net operating income (sometimes given as ‘net rent’ in commercial property ads) of $80,000 per annum and the cap rate from recent sales in the area is 7%. To use the 7% in the equation we divide 7 by 100 to give 0.07 (changing the percentage to a decimal). The estimated value of the property would therefore be:
Market value = $80,000 / 0.07
Market value = $1,143,000
This is one of the methods that Valuers use to value commercial property. It can help in your property research and you can also use it to negotiate price with the vendor if they are asking more for the property than these calculations say the property is worth. Using this figure you can now explain to them how you have calculated the price you are willing to pay and negotiate from there!
Let’s use the formula with a few properties so you can see how it can be used for your initial calculations. I took these examples from actual commercial real estate ads so this is something you can play around with when you’re looking at ads. Note that I use the words ‘net income’ instead of ‘net operating income’ simply because it’s shorter! I also swap between the words ‘yield’ and ‘cap rate’ so you get used to them meaning the same thing.
Example 1 Calculate Yield for a Shop in Newtown
A shop for sale in Newtown, NSW is tenanted with a net income of $115,000 per annum and an asking price of $2,275,000. What is the yield (Cap Rate)?
Yield = net income/ value
= 115,487 / 2275000
= 5% Yield (Cap Rate).
Does 5% yield suit your investment strategy? Often, country areas have higher yields so that may influence your decision about where to invest.
Example 2 Calculate Market Value for KFC, Central Coast
Retail property currently tenanted by KFC on the Central Coast of NSW. There are three years left on their ten year lease with lease options to 2034.Net income $276,230 per annum. Expressions of Interest invited. You have decided that you want a yield of 7% for your next commercial investment so you can calculate what price you would be willing to pay:
Market value = net income / cap rate (yield)
=$276,230 / 0.07
So now you have a rough idea of what you might be willing to offer as an Expression of Interest. You can then ask the Real Estate Agent what they are expecting and do further research if their expectation is near your value estimate
Example 3 Calculate Yield for Hornsby Warehouse
Industrial Warehouse in Hornsby, NSW asking price $860,000 with net income of $46,000.
Cap rate = 46,000 / 860,000
= 0.05 or 5% yield
Does this yield suit your investment strategy?
Example 4 Calculate Market Value for Glenunga Offices
Offices in Glenunga, SA currently leased until June 2018 with two rights of renewal each for 5 years. Net income of $97,760. Average yield (using a figure from www.savills.com.au) is 8% for A grade buildings in the Adelaide fringe. Calculate the market value?
Market Value = net income / yield
= $97,760 / 8%
=97,760 / 0.08
Is this purchase price within your budget? If so, with 8% yield, you may want to get more information about this property.
Example 5 – Calculate Net Income for Newtown Retail Premises
A retail/consulting rooms property for sale in Newtown, NSW is listed as ‘Offers above $900,000’. The advertisement says it has strong yield, established and stable tenant and guaranteed income.
To get indicative Cap Rates/Yield you can visit sites such as www.savills.com.au and look under their Research tab to find a guide to the yield. The website gives an upper and lower value, 4.5% and 7.25%) so I’ll do the calculation for both values so we have a best and worst case idea of the net rent.
Net income = market value x yield
= $900,000 x 4.5%
= $40,500 per annum at the lower end, and
= $900,000 x 7.25%
= $65,250 per annum at the higher end.
Now you can look at what the loan repayments will be for the amount you need to borrow to purchase the property and, using the Cash Flow formula above, you will have an idea of whether this will be cash flow positive for you.
So these examples show how you can use just a couple of numbers that are quite easy to get, to do your initial assessment of a commercial property. If the figures are what you’re looking for it would then be time to call the Real Estate Agent to get more detailed information!
Do you have any questions about these calculations? Have you bought commercial property before and used these or other methods to assess the suitability of it? Do you have any experiences with commercial property that you’d like to share?