Two Real Estate Terms you MUST Know (and an overview of underwriting)

The most important figure needed to value commercial real estate is NOI—Net Operating Income. I mentioned this concept in my last blog post, but I want to add a little detail. It is a real estate specific metric because, when calculated, it exhibits a property’s money-making ability which is what investors, lenders, and other professionals care about. Real estate is a highly leveraged and depreciated asset class, so other financial metrics do not accurately capture the revenue potential of real estate investments like NOI does.

NOI is equal to all property revenues minus operating expenses. Revenues are mainly from rents which tenants pay, but can also include income from late fees, charging for parking in a parking garage, renting out the roof to a cellular company to place a cell tower, or even from a vending machine. These line items are considered “Other Income”, and can add—sometimes significantly—to the value of a property. Operating expenses include anything that is necessary to run and maintain the entire property: property management fees, insurance, utilities, property taxes, maintenance, etc. Depreciation, amortization, debt payments, and capital expenditures are not included in operating expenses.

Maclennan Investment Group

Once NOI is calculated, the next step is determining a capitalization rate for the property. A cap rate, as it is referred to in the industry, is simply the NOI divided by the value of the asset. If the NOI for a property is $6 and the property is worth $100, then the cap rate is 6, or 6%. Often times, cap rates are used to determine the value of property as opposed to vice versa. Based on comparable properties, and properties types (office, retail, multifamily, etc.), cap rates can be determined to use as a basis for imputing value. If we know that the cap rate for a multifamily property is 6, and the NOI is $6, then we divide $6 by 0.06 to calculate a value of $100 for the property. The lower the cap rate is for a property, the higher the value will be. Multifamily properties tend to have lower cap rates than property types like office and retail because apartments are viewed as a safer investment. Back to finance: the riskier the investment, the higher the return, or the higher the cap rate.

Forbes

Underwriting (!!)

We are finally to the fun part, the actual practice of underwriting a real estate property.

First off, a disclaimer: all financial models are different (and not created equally). Each person in my office has a different way of underwriting deals, but they all boil down to the financial return metrics which is what investors and developers care about. Some are more advanced and polished than others, but if correctly built, should have the same outputs. Secondly, a financial model is simply a set of assumptions that flow through a framework, to spit out return metrics and show you how a property could potentially perform.

FINANCIAL MODELS ARE ALWAYS WRONG. Always. There is probably a greater chance of winning the lottery as correctly predicting the future performance of a real estate asset. Knowing that a model is always wrong, the goal is to refine your underwriting to get as close as possible to the most likely scenario. It is a process, and continues until a building is purchased or a development is completed. In my next blog, I am going to give an overview of the various aspects of a model, delving into the specifics of the assumptions part of the underwriting process.