Buying Commercial Real Estate

Exchanging is important because it is a method of marketing property that is not limited just to tax deferral. The all important tax deferral concept of exchanging is still valid especially in cases where depreciation basis may not be a factor. A taxpayer who is exchanging vacant land for a larger tract of vacant land and is interested in preserving equity by deferring the gains, will often desire a 1031 tax deferred exchange. Older taxpayers may seek out the 1031 exchange when the holding period may exceed their lifetime and offer stepped up basis after death. Ultimate tax deferral at death may be a motivation to exchange for certain older taxpayers. A complete discussion of the 1031 tax deferral concept is beyond the scope of this text and the emphasis is on marketing and not on tax deferral. 2 However we will briefly examine the general concept of tax deferral. Assume a sale nets the owner $100,000, creating a tax liability of $20,000. If the owner exchanges his property for a qualifying like-kind property and complies with the rules of Section 1031, the entire tax may be deferred. An outright sale would reduce the equity by $20,000, leaving the investor only $80,000 to invest. Given the opportunity to invest the proceeds in an investment with an after tax return of ten percent on the equity invested, the following after tax cash flows to the investor would be
realized.

There are three general methods appraisers use to value commercial real estate:

1. Cost Approach
2. Sales Comparable Approach
3. Income Capitalization Approach

The Cost Approach arrives at a value by determining what it would cost to replace the property being assessed. The appraiser will conduct a study which will determine what it would cost to buy a similar piece of land and construct a similar building. This value is also referred to as the replacement cost.

The Sales Comparable Approach analyzes recent sales on comparable properties and makes assumptions based on the sale price per foot and then applies that sale price per foot to the subject property in order to arrive at a current market value. The Income Capitalization Approach analyzes the income and expenses generated and incurred on the property and then capitalizes the Net Operating Income (cash flow before debt service) in order to arrive at a current market value. Typically, appraisers will conduct all three approaches and then perform some sort of reconciliation analysis in order to arrive at a single final concluded market value. Despite what the appraisal states however, lenders will still conduct their own valuation analysis.

The most popular and heavily relied on by lenders today, of the three methodologies listed above, is the Income Capitalization Approach. (This assumes of course the property does in fact generate income. Some commercial real estate loans are made on development or construction projects for instance that do not generate income and therefore this approach would not apply. The appraiser’s analysis only serves as a means of checks and balances to the lender’s own analysis. This is a common misconception among borrowers. Some borrowers feel that the appraised value should be the value underwritten by the lender. Unfortunately for borrowers that is not always the case.

Reverting back to the definition of the Income Capitalization Approach, we know that in order to arrive at a value, a cash flow figure is capitalized using a capitalization rate. The definition of a capitalization rate “cap rate” is expressed in terms of the following formula:

Cap Rate Net Operating Income / Value (or Purchase Price)
A cap rate is merely an expression of the unleveraged annual return on one’s investment. It measures the borrower’s cash flow before debt service (NOI) in terms of a percentage of the value of the asset. In terms of underwriting however, the cap rate is an assumption that is used to back into the underwritten value of the asset. From an underwriting standpoint, lenders restructure the formula as follows:

Value Net Operating Income / Cap Rate (input)

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