Double Your Commercial Equity | Cheat the System Legally
If I told you that, with one move, you could double the equity in your commercial property, you’d likely call me crazy. And, while I completely understand this initial take, I’d love to show you a strategy to accomplish this increase in value!
By understanding the power of the commercial real estate value formula, investors can make small operating changes that lead to enormous increases in their equity in a property.
In the following article, I’ll discuss this value formula and the role it plays in massively increasing your commercial equity. Specifically, I’ll dive into each of the following topics:
● An Overview of the Commercial Real Estate Value Formula
● Forced Appreciation and Commercial Equity
● Numerator Value: The Equity Impact of a Dollar
● Denominator Value: Reducing Cap Rates to Drive Equity
● Final Thoughts
An Overview of the Commercial Real Estate Value Formula
Valuation techniques represent one of the primary advantages of commercial real estate over its residential counterpart. Residential properties appraise based upon local comparable sales and listings (a.k.a. market “comps”). You’re limited in your ability to improve a home’s value on your own - regardless of the amount of work you put into improving a place - instead needing to wait for the overall market to appreciate.
Commercial properties, on the other hand, use a far different appraisal technique. Due to each property’s fairly unique nature and the fact that they’re inherently income-producing, appraisers use a commercial real estate value formula to appraise these properties. The formula includes the property’s capitalization, or cap, rate, its net operating income (NOI), and its value:
● Cap Rate = NOI / Value
Or, rearranged to solve for value:
● Value = NOI / Cap Rate
Forced Appreciation and Commercial Equity
Taking a step back from real estate, I want to look at the above value formula mathematically. Returning to the topic of this article, our goal is to increase equity in a commercial property, which we can accomplish by increasing value (assuming our ownership stake remains the same).
From a mathematical standpoint, we can increase the value in either of the following ways:
● The numerator approach: If we increase a commercial property’s NOI (the numerator in the above formula), the value of the property will also increase.
● The denominator approach: Similarly, if we decrease a commercial property’s cap rate (the denominator above), it will have an inverse effect and increase the property’s value.
For investors, the big takeaway from above revolves around control. More precisely, by affecting a commercial property’s NOI or cap rate, investors can actually force those properties to appreciate, something not possible with residential real estate.
In the following two sections, I’ll dig a little deeper into each of these forced appreciation methods.
Commercial real estate professionals can assist investors in identifying ways to increase a property’s NOI. Need help connecting with reliable ones in your area? Drop us a note!
Numerator Value: The Equity Impact of a Dollar
Put simply, when it comes to forcing appreciation with NOI, small increases in income add up to big increases in value. For example, assume an apartment owner finds a way to increase NOI by $1/month, and let’s assume a cap rate of 5%.
● Increase in total NOI ($1 x 12): $12
● Increase in value ($12 / 5%): $240
Yes, that means that, by only finding one dollar of additional monthly income, this investor increased the value of the building by $240! And, this will have an even more profound effect on equity.
Assume investors purchased a stabilized apartment building for $1,000,000 with a 70% LTV acquisition loan and put in an additional $100,000 in value-add improvements ($300,000 initial equity + $100,000 in improvement costs).
If the investors purchased at 5% cap rate, the initial NOI would be $50,000 ($1,000,000 x 5%). Now, assume that the $100,000 in value-add improvements increases the NOI by $20,000 to $70,000 total (a 40% increase). Here are the new details:
● Initial Value: $1,000,000
● New Value ($70,000/5%): $1,400,000
● Initial Equity: $300,000
● New Equity ($300,000 initial plus $400,000 increase in value): $700,000
In other words, by making some improvements to a commercial property and increasing NOI by 40%, these investors more than doubled their equity! And yes, this is only a hypothetical example, but the important takeaway is the outsized impact increases in NOI can have on investor equity.
Denominator Value: Reducing Cap Rates to Drive Equity
In addition to NOI, investors can force appreciation of commercial properties by lowering cap rates. While to some extent the market dictates cap rates, investors can influence them.
In general, higher quality tenants (i.e. those with better credit) drive cap rates lower, as this limits risk in a property. Related, having tenants sign longer-term leases can also drive down cap rates, as longer leases further decrease risk.
As a result, if investors purchase a commercial property and take steps to increase both the quality of the tenant and the average lease duration, they can drive down the property’s cap rate and, by extension, increase its value.
For example, assume investors buy a four-unit office building for $1,000,000 with a 70% LTV acquisition loan and 5% cap rate ($50,000 NOI), meaning they have initial equity of $300,000. Now, let’s say that they change their leasing strategy from month-to-month to long-term, mandating new tenants have better credit and sign minimum five-year leases. In doing so, they successfully reduce the cap rate from 5% to 4%, leading to the following results:
● Initial Value at 5% cap rate: $1,000,000
● New Value at 4% cap rate ($50,000/4%): $1,250,000
● Initial Equity: $300,000
● New Equity ($300,000 initial plus $250,000 increase in value): $550,000
Without doing anything to the property’s NOI, these investors nearly doubled their equity solely by improving tenant quality and lease duration, demonstrating the appreciation power of cap rate reductions.
Feel free to drop us a note if you need help analyzing commercial real estate cap rates in your market. This analysis can seem challenging, and we’re happy to help!
Final Thoughts
Regardless of what commercial real estate investing strategy you use, the commercial value formula can play a huge role in property appreciation. And, when your property value increases, your equity in that property increases, as well.
Through increases in NOI, reductions in cap rate, or some combination of the two, investors can proactively force appreciation and increase their equity in a commercial property.
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We recognize that, even after outlining the above information, developing a strategy to increase your commercial property’s equity can seem daunting.
That’s why we’re here to help. The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!