Properly Underwritten Cap Rate Calculations for Commercial Real Estate. It is not a pro-forma folks.

I was having dinner with some friends the other night, and in the group was a fellow real estate professional. He primarily sells residential, but does a bit of commercial work from time to time. He was telling me about a commercial property he has for sale, and commented “it should really sell, it is XX cap” Instantly my mind starting racing, well, sure it is a XX cap rate, but with what financial underwriting standards?

I’ve seen countless sellers over the years haul me into their office, wanting to list property for $XXXX dollars, which by their calculations is a 9% cap rate. They have a gross revenue number of all the rents collected, and on the expense side, property taxes, property insurance, and some common area maintenance expenses(i.e., sanitation, landscaping, irrigation) They have failed to include any type of “other expenses” that are so crucial to the real earning power of an asset.

The big ones in my mind that get left out of an owner’s calculation are 1)Vacancy Allowance, 2)Credit Loss, and 3) Capital Reserves.

Vacancy. Your property is fully leased. Congratulations! But they don’t stay that way. Even more so in this era that “Too Big to Fail” no longer exists. If you have great tenants, with solid financials and a bright future, there is still a vacancy allowance. What if you superstar tenant outgrows your space? Decides to invest in the market and buy their own building? There is always a vacancy risk. And one should be factored into any NOI calculation.

Credit Loss. Credit losses are most common when a tenant stops paying, or has a reduction in the amount they are paying, resulting in a credit loss to the owners income. However other things can also be considered a loss, and that charge credited against the income. A leaking roof that causes an inconvenience to the tenant, and thus resulting in a rent credit to appease them. An A/C unit breaks down on a hot summer Monday, no 5 ton air handlers are available for a week. Your law firm tenant does not find sympathy in your AC contractor’s supply issues. More credit loss; this is always a factor, and gets greater with the number of tenants a property has.

Capital Reserve. My grandmother’s saying regarding real estate, “A house is like a hungry dog, you have to throw it a bone once in a while.” A 30,000 SF Office building is hungry ALL the time.

These three items should always be factored in, but what we can debate is the percentages and amounts per square foot to use. 20 cents PSF or $1.20 of capital reserve is debatable based on location, age, tenant load factors, etc. A great AAA rated tenant base may justify a low 1% vacancy allowance. And maybe your fatastic management company never slips up and issues rent credit. All three scenarios are highly unlikely, and one of them has to be a significant expense to the property.