Kimberly McClay Aselton, Coldwell Banker Commercial Benchmark
Do you ever feel unlucky? Like your timing is always off? Have you ever found yourself saying “If I only had his luck?”
I was one of those people, always wondering why other people seemed to make a profit on every investment they made. We’ve all heard the idiom, “You make your own luck,” but what does that even mean? I don’t know how to make luck.
“Knowledge is power;” now that, I understand. I have found that the most successful investors make certain they have all the knowledge and information needed to make an excellent investment. When considering investing in commercial real estate, most people call a commercial broker and ask them to find a great investment property for them. That makes sense. After all, they must understand the market. It is very simple, many will say, “the higher the cap rate, the more money you will make.” Having a broker that knows the market is critical, but they must also understand basic investment measures and what those measures mean to you, the investor.
There are four commonly known investment measures that most brokers and investors use: Cap Rate, short for capitalization rate; Cash on Cash, commonly known as ROI (Return on Investment), IRR (Internal Rate of Return); and GRM (Gross Rent Multiplier).
The most commonly used term is Cap Rate. In a nut shell, Cap Rate is a value for your money at any given point in time, or what kind of deal you are getting on the property. It is NOT a rate of return in any way. Cap Rate is determined by dividing the Net Operating Income (NOI) of a property by the current market value (price) of that property. You can look at it as like an interest rate charged. It is a determination of risk. Investors can use cap rates to compare the relative risk associated with different properties. Since Cap Rate determination does not consider how you purchase the property (cash or leveraging someone else’s money adding financing costs to you), the Cap Rate on a property will not change based on how the investor buys the property. It is specific to the property, and therefore does not change for each investor.
Cash on Cash is completely different. It is the annual cash flow divided by your investment equity. Your annual cash flow is your NOI minus any expenses incurred with borrowing any portion of your initial investment (principle or debt repayment and interest). Using this way to measure, you are taking into account what the money is costing you, where as with Cap Rate, you do not. When using this method, the ROI will vary for each investor due to differing interest rates and down payment amounts.
Internal Rate of Return (IRR) is often used by Pension Funds, Life Companies, Investors and Brokers. IRR measures the profitability and true return on an investment. Unlike the other investment measures, IRR looks at the entire life of the investment, not just a snapshot at a given point in time. This measure considers financing, tax, as well as change in cash flows from operation and appreciation through sales proceeds.
The Gross Rent Multiplier is used mainly with multifamily buildings and therefore is less commonly used. It is the Value (price) divided by the potential rental income for the property. It does not take into consideration the property expenses which can vary greatly between properties.
There are so many variables that go into determining whether a commercial property is a good investment for you, and each of the four commonly used investment measures do not take them all into account. If you are considering an investment in commercial real estate, get a broker who specializes in commercial real estate. Make sure the broker can explain how they are determining investment recommendations for you. Make sure the broker understands your individual investment goals: how long do you intend to hold the investment, monthly revenue needed, the ROI you are trying to obtain, etc. Also, most importantly, make sure your broker thoroughly understands the different investments measures and which one makes the most sense for evaluating YOUR investment opportunities. Knowledge IS power…make sure your broker has it.