Property valuation plays an essential role in commercial real estate. Both an art and a science, property valuation helps real estate investors, operators, lenders, brokers and other real estate stakeholders to assess the value of a given real estate property. 

This comprehensive guide explains property valuation in detail, including key concepts, methodologies and its significance in commercial real estate. 

In this guide to property valuation, you will learn:

Property valuation is important for multiple reasons, including:

Therefore, a property’s valuation plays a critical role in commercial real estate. Investors, operators, asset managers, lenders and other stakeholders all depend on a property valuation for an independent analysis of a property’s worth. Armed with this knowledge, these real estate actors can make more informed decisions.

When it comes to property valuation, it’s important to understand several key terms. For example:

Market value is the highest price that a potential buyer would pay for a commercial real estate property and the minimum price that a potential seller would accept. Consider market value to be a measure of financial value that buyers and sellers use to transact on a property, with both buyer and seller entering into the transaction fully-informed and without undue pressure. Rather than basing valuation on historical value or original purchase price, the market value is based on recent comparable transactions, condition of the property and other factors.

The use value of a commercial property is based on the designated purpose of the asset. For example, a commercial property with a residential use would be valued differently than an industrial property or a senior housing facility. 

Demand is high when there is increased interest and popularity for a particular property or market. When demand is high, prices rise. With high demand, buyers may be more willing to pay higher prices to acquire a desirable property, which can benefit sellers. In contrast, low demand can indicate lower prices and a buyer’s less willingness to pay a premium for a real estate asset. 

Supply is the amount of available commercial real estate properties in a particular market that are comparable to the target property. Investors look at inventory to assess the amount of readily-available property in a particular market. If there is high demand and low supply in a market, prices can be expensive to acquire a target property.

The utility, or use, of a commercial real estate property refers to the property’s ability to meet the needs and goals of a particular buyer or owner.

Transferability refers to the ease with which ownership right of a particular commercial real estate property can be transferred from a seller to a buyer. On a relative basis, commercial real estate properties that are unencumbered and can be transferred more easily generally have higher valuations.

There are multiple types of property valuation methods that investors, asset managers, lenders and other stakeholders use to determine the value of a commercial real estate property. Here is a snapshot of some popular valuation methods:

The comparable sales method uses recent transaction data of similar properties in the same neighborhood or market to arrive at a value for the target property. So, this valuation method determines the value based on precedent sales transactions. 

The income capitalization method is based primarily on the amount of income an investor can expect to generate from a particular property. Rather than focus on transaction data, this method focuses on income generation. To leverage this method, calculate net present value of of a future stream of income the property is expected to produce. 

If there is a lack of comparable sales data or if the property is a new construction, the cost approach can be an effective valuation method. The cost approach focuses on the cost of land plus the depreciated cost of the building. 

The value per door method is most relevant for apartment buildings and determines the value of a building based on each individual unit. For example, if a building is valued at $10 million and has 100 units, then the
value per door is $100,000.

Valuation are important for various real estate stakeholders. For example, investors and asset managers use valuations to help them make more informed decisions. When they know the independent value of a property, they can use this data to make a reasonable offer or use the valuation as a comparable to build a new project or buy a similar asset. 

Lenders use valuations to determine the safety of their commercial real estate loans. Lenders need to understand how capital is at risk for a given property, and a valuation helps them gauge both the risk of the loan and the underlying asset. 

An appraiser is a real estate professional who values a commercial real estate property. Through both art and science, appraisers use their expertise to deliver an appraisal, which is a comprehensive analysis of a property, which could include location, the property’s condition, comparable assets and precedent transactions, and other factors which drive value. 

Whether you’re an investor, asset manager, buyer, seller or lender, a commercial property valuation is an essential tool that sets the foundation for any real estate transaction. By understanding the key principles and terms for real estate valuation, you can make a more informed decision about a given property and investment decision. 

The Ultimate Guide to Property Valuation In Commercial Real Estate 

Whether you're an investor, asset manager, lender, broker or other real estate professional, understanding commercial real estate asset classes can help optimize your investment decision-making. Each class including common classes such as Class A, Class B or Class C – represents a different level of investment risk and return. These classes reflect both the physical and geographical conditions of a property, while also allowing real estate professionals to communicate easily about properties using a standard rating system.

In this comprehensive guide, you will learn:

Definitions of Class A, B and C properties

While there are multiple ways to classify a real estate property, including sub-classifications, the standard classification includes Class A, Class B and Class C ratings. 

Here is a breakdown of the three most common real estate asset classes:

Class A buildings represent the highest-quality buildings in a real estate market. They are typically newer assets (less than 10 years old), are located in desirable areas, and offer top amenities, design and finishes. Class A properties are considered turnkey; they don’t require any major renovations. With low vacancy rates and premium rent, a Class A building is considered a highly-desirable property. Class A buildings have professional asset managed and typically attract top-quality tenants.

Class B properties are older than Class A properties, may not have a professional asset manager, and tend to have lower rents. Investors
identify Class B as “value add” investment opportunities because they can be renovated to improve physical appearance, amenities, common areas and finishes. Post-renovation, a Class B property could become a Class B or Class A, for example, depending on the amount of renovation. In contrast to Class A properties, Class B properties typically offer a higher cap rate because they are considered riskier assets. That said, Class B properties can still be in good locations and represent solid investments.

In contrast to Class A and Class B buildings, Class C properties are typically older (e.g., more than 20 years old), are located in less desirable areas, and often require significant capital expenditures for
renovations. With Class C buildings, vacancy rates are typically high, and tenant income is typically low. Due to the condition of the properties and less desirable locations, Class C properties tend to be considered highest risk to investors. As such, like Class B properties, Class C properties often are sold at higher cap rates.

Types of buildings within each classification

Asset classification of a property exists across multiple types of buildings in commercial real estate. For example:

 From urban skyscrapers in New York City to small office buildings in suburban Chicago, asset classification can be driven by quality, location, and infrastructure.

 Brand new apartment buildings with high-end amenities might be classified as Class A, while older apartment buildings that need value-add improvements may be considered Class B.

 Retail stores on Rodeo Drive in Beverly Hills are classified as Class A properties while older strip malls in less desirable locations may be characterized as Class C. 

 High end, luxury hotels in New York are considered Class A properties, whereas rundown motels in rural areas may be considered Class C.

Key characteristics of each asset classification

If you’re wondering what are the key characteristics of each asset classification, here’s a helpful snapshot. 

Why should investors, asset managers, lenders and brokers care about asset classification? There are several reasons why, including:

For shrewd real estate professionals, understanding the differences among Class A, B and C assets in commercial real estate is essential to make informed decisions about risk-reward, investing, asset management, tenant base, capital expenditures and long-term positioning. 

Comprehensive Guide To Commercial Real Estate Asset Classes

With the prospect of an uncertain economy, commercial real estate investors should evaluate their portfolio to manage risk during a potential downturn. To build a portfolio with steady returns, it’s helpful to understand which types of real estate best withstand economic downturns. Keyway, the leader in technology-powered, small-scale real estate investing, analyzed which commercial real estate sub-sectors performed best during the Great Recession of 2008 to inform investors which sub-sectors may perform well in the current economic environment. 

For months, commercial real estate transactions have slowed as a result of higher borrowing costs and wide bid-ask spreads. According to Real Capital Analytics, in 4Q 2022, transactions declined 61% year-over-year. This decline in transition volume has left many institutional investors and family offices on the sidelines until either borrowing costs subside or the bid-ask spread narrows. 

Despite these macro headwinds, shrewd investors can deploy capital into real estate sub-sectors that are most resilient in an economic downturn. 

To find which companies meet this criteria, we analyzed the Census Business Dynamics Statistics. Specifically, we examined exit rates – how often a company leaves a location, thereby forcing the landlord to find a new tenant – of various companies during and after the Great Recession (2007-2012). Using data from Yardi, we also analyzed occupancy rates and asking rents in the Dallas-Ft. Worth region from 2011-2012. 

In the Great Recession, nearly 10 million people lost their homes to foreclosure, creating a glut of renters. In this housing downturn, there are a glut of renters – not necessarily due to home foreclosures – but due to persistently unaffordable home prices and limited supply. 

Given this market dynamic, there is strong demand and growth for Class B and Class C multifamily properties. When we look at “months of negative estimated revenue growth” for multifamily properties in a downturn, we have observed certain types of properties rise to the top as stable investments. For example, Class B properties showed only eight months of negative growth from 2011-2022 — compared with 30+ for other property types. 

Why? When a downturn happens and tenants experience financial pressure, tenants often “move down a rung” on the property ladder. That means those who lived in a Class A building might move to a Class B property. Similarly, Class B tenants relocate to a Class C building. As a result, Class A buildings have higher vacancies and lower asking rents. We’ve observed this trend over time in the Dallas-Ft. Worth region, where Class B and Class C buildings have shown the best net absorption rates over time. 

At Keyway, we like to focus on Class B properties that not only show historic stability, but also serve an important role in communities by keeping affordable housing in desirable neighborhoods. 

Nursing care, assisted living & residential care facilities 

Nursing care, assisted living and residential care facilities — especially skilled nursing facilities and residential facilities for intellectual and developmental disabilities — showed a much healthier exit rate through the last downturn. Given 70% of people age 65 and older will need some type of long-term care during their lifetime, we expect even more stability in this subsector in the future. 

What drives this stability? In addition to increased demand, these properties have relatively low exit rates, making them attractive long-term investments. 

At Keyway, we spend significant time analyzing physicians’ and dentists’ offices, both of which have a better overall exit rate than our control group. 

With both physicians’ and dentists’ offices, the size of the practice is correlated with exit rates. For example, smaller practices of one to four employees have the highest exit rate (8-12%). Given the low headcount, the departure of one or more employees due to attrition or retirement could cause the practice to move locations. 

We also observed higher exit rates among larger companies of 100+ employees. Why? These larger organizations make strategic decisions about individual practice locations based on profitability or staffing, which can lead to moving locations more regularly. 

The sweet spot for both physicians’ and dentists’ offices is the mid-sized, regional practices that have 5-100 employees. These practices generally remain in their locations, creating long-term stability for their landlords. For example, dentists’ offices with 5-99 employees have an exit rate of only 0.7%. 

Interestingly, dental practices are more stable than physicians’ practices, with lower exit rates. 

While warehouses did slightly better than our control group of retail trade and professional services, warehouses can perform better in a downturn relative to other industrial properties. 

For example, in the Great Recession, warehousing businesses experienced a 42.4% five-year survival rate, which is higher than its industrial peers. 

The Best Real Estate Sectors In An Economic Downturn

Borrowing a commercial real estate loan can be an important step to fund a real estate acquisition, expansion or development. However, to mitigate their risks, lenders often seek additional financial assurances from a prospective borrower. A personal guarantee is one such assurance that lenders may require to issue a commercial real estate loan. 

A personal guarantee is a legal and financial commitment from an individual real estate owner who pledges personal assets as collateral for a commercial loan. If the borrower, who is also known as the guarantor, defaults on the real estate loan, the lender can pursue the guarantor's personal assets to pay back the real estate loan. 

You may be wondering why a personal guarantee is necessary to secure a commercial real estate loan. In commercial real estate financing, lenders want to minimize underwriting risk across their loan portfolio to avoid default. A personal guarantee provides lenders with lower risk exposure and provides more confidence that the loan can be repaid if the borrower defaults. When a borrower provides a personal guarantee, a borrower may be more likely to get a real estate loan approved by the lender.

There are several types of personal guarantees, including:

 With an unlimited personal guarantee, the guarantor agrees to be liable for the entire loan, including principal, interest and other costs, in case of loan default. If the borrower defaults, the lender can access all of the guarantor's personal assets, without limitation, to recover the debt.

With a limited personal guarantee, a borrower can limit personal financial exposure by capping liability at a mutually agreed upon amount. If a borrower defaults on a real estate loan, the lender can only recover the borrower’s personal assets up to the agreed upon amount. 

In commercial real estate financing, there are several types of borrowers who may be asked to provide a personal guarantee. For example:

However, not every real estate loan requires a personal guarantee. For example, a lender may be willing to enter into a non-recourse loan, which means a lender cannot recover personal assets when a borrower defaults on a real estate loan. Who qualifies for a non-recourse loan? Typically, a borrower with a strong financial position and track record of financial success may qualify for a non-recourse loan. However, each lender decides whether a non-recourse loan is appropriate given the specific circumstances and borrower profile.

If you are asked to provide a personal guarantee, it’s important to understand the potential implications and risks. For example, here are some items to consider

Before signing a personal guarantee, it’s essential to explore alternatives to a personal guarantee. For example, consult with other banks and lenders that may not require a personal guarantee and who are open to non-resource financing.

Are there any alternatives to a personal guarantee? In many cases, a personal guarantee is required for many borrowers who seek commercial real estate financing. However, here are some ways that a borrower can reduce their financial exposure: 

While real estate lenders use a personal guarantee to reduce their risk profile, borrowers risk their personal assets in case of loan default. Borrowers should understand all aspects of a personal guarantee, including both benefits and risks, before agreeing to a personal guarantee. While a personal guarantee may be necessary to secure financing, borrowers should also be careful to protect their financial assets. 

Personal Guarantees in Commercial Real Estate Financing: A Comprehensive Guide

Real estate lease management is essential to ensure the success and profitability of a commercial real estate property. Whether you’re an investor, property manager, broker, landlord or tenant, efficient real estate lease management can help minimize expenses and maximize returns. This guide to effective real estate lease management will teach you everything you need to know to optimize your leases. In this guide, you will learn the following strategies:

The first step to effective real estate estate lease management is a desktop lease audit. A desktop lease audit is the process of error identification in your leases to ensure that you’re not over-paying for key expenses such as common area maintenance (CAM) charges, insurance or taxes. 

Tenants should conduct a desktop lease audit regularly to ensure
the accuracy of landlord invoices and their compliance with the underlying lease. Since lease structures and payments can change over time, it’s critical to ensure that rental payments are accurate. For example, check that base rent, rent escalations and other performance metrics are calculated correctly. 

Similarly, operating expenses can vary by lease and property. Both landlords and tenants should check invoices, payments and lease terms to ensure the pro-rata split between tenant and landlord has been followed properly. For example, here are some key terms to monitor to confirm invoices match the lease terms:

Conduct a desktop lease audit at least annually. The first audit is most important, since it sets the baseline to correct errors in calculations and payments before they compound.

Sometimes, a desktop lease audit is insufficient and a more comprehensive, full-scale lease audit may be necessary. Here are several examples that may trigger the need for a full-scale lease audit:

A full-scale audit is a more comprehensive type of audit than a desktop audit. During the full-scale audit process, it’s important to
review all leases, invoices and payment processes to ensure accuracy. Pay attention to invoicing errors such as:

Leverage automated technology to streamline lease management
administration, including rent calculations, invoicing and payment processing. This not only saves time but also reduces manual errors and ensures accurate financial data. 

Lease management software also can be used to facilitate tenant
communication, maintenance requests and notifications. By leveraging technology, real estate investors, operators and property managers can improve efficiency, optimize cash flow, increase tenant satisfaction and gain a competitive advantage.

Your ability to optimize subleases is critical to improve efficiency and reduce costs. If a tenant has unused space due to staffing or operational changes, for example, a tenant may sublease that space to a third party.

In a sublease, a subtenant could pay rent directly to the primary tenant or the landlord. With multiple subleases, it can become difficult to track payments accurately, which can adversely impact accounts receivable. For example, each sublease can have a different rent amount, operating expenses, insurance and taxes. 

To avoid billing accuracies and accounting errors, lease management is especially important when organizing subleases. Maintaining a
detailed schedule of each sublease, including lease terms and payment schedules, are critical to maintain best practices. Landlords should have separate billing processes for each sublease invoice. Ideally, the subtenant pays the landlord directly to ensure accuracy. 

Commercial real estate leases can include incentives and allowances to help tenants offset the cost of the underlying lease. For example, a landlord could include an allowance for tenant improvement, which a tenant can use to remodel the leased space. Tracking tenant improvement allowances can be challenging, depending on how the
lease is written. For example:

Tenants should have a clear methodology to track available tenant improvement allowances as well as a schedule of availability. This includes, but is not limited to, reviewing the balances of tenant allowances. Similarly, landlords should have a clear process to track spending on tenant improvements, including invoice and vendor management.

Commercial real estate leases contain important dates, including the lease term, renewal options and termination options. Knowing the end of the lease term is especially important for landlords and tenants to understand. Why? A tenant could face financial penalties for staying in a property beyond the end of the lease term. Similarly, a tenant may not be able to move to a new property if the existing tenant hasn’t vacated the premises.

Tenants also could pay for a property after the end of their lease term if the tenant didn’t properly notify its Account Payables department
of the lease termination. If payments are automated or the landlord continues to send an invoice, a tenant could continue to pay rent despite not using the property. 

Landlords and tenants should institute automated notification alerts to ensure that critical dates are known in advance. For example, alerts
should be established to notify landlords and tenants when a lease is near its expiration date and there is no option to renew, terminate or purchase the property. Automatic notifications also can be sent to the Accounts Payable department to ensure proper communication to end lease payments on a specified date.

Budgeting and forecasting are essential for any commercial real estate property. However, budgeting and forecasting for leases can be more complex. For example:

Since each lease is unique, every property can require a different pro rata split for expenses between the landlord and tenant. These accounting issues become magnified as landlords and tenants budget and forecast across multiple properties.

Maintaining and continually updating forecasts for each lease will help to ensure higher financial accuracy. Always compare invoices and payments with the underlying lease to gain a more accurate financial
understanding of total lease costs.

Effective commercial real estate lease management is a multifaceted process that requires a strategic and proactive approach. By conducting thorough lease audits, leveraging technology, optimizing subleases, and coordinating with accounting departments, real estate investors, brokers, landlords, tenants and property managers can optimize lease management and save money.

By integrating these best practices, real estate stakeholders can reduce errors, avoid overpayment and improve the long-term profitability of their commercial real estate properties.

How To Optimize Real Estate Lease Management

If you own commercial real estate, you may be considering several options to monetize your investment. A sale-leaseback is one strategy to explore to maximize value and financial return.

In this article, we will discuss everything you need to know about a sale-leaseback, including:

A sale-leaseback is a real estate transaction in which a real estate owner sells a property to a new owner and then leases back that same property through a long-term lease. Also known as a sale-and leaseback or a leaseback, the transaction enables the seller to become a lessee and the new owner to become a landlord. 

Real estate owners use sale-leasebacks to raise capital or divest real estate assets without selling equity ownership in their underlying operating business. Once the property is sold to a new investor, the seller enters into a lease agreement for an agreed-upon rent for a set duration. Once a sale-leaseback is completed, the seller of the real estate property becomes the lessee and the purchaser becomes the lessor. As a lessee, the seller can raise capital, divest a real estate asset, and use the real estate to operate its business. 

Sale-leasebacks are attractive to real estate owners who want to use an alternative, creative strategy to raise capital other than traditional debt financing or equity financing. 

A sale-leaseback offers several advantages to both sellers and purchasers of commercial real estate property.

Sellers of real estate can enjoy the following benefits through a sale-leaseback:

Purchasers of real estate can use sale-leasebacks to gain several advantages, including:

While there are many advantages to entering a sale-leaseback, buyers and sellers should weigh the disadvantages as well. For example:

 A seller/lessee could default on the lease, which could be a material risk for a buyer/lessor. If a buyer/lessor cannot secure a replacement tenant, the buyer could risk lost rental income and vacancy.

As a real estate owner, the buyer/lessor is financially responsible for repairs, maintenance, and upgrades.

As a commercial real estate owner, there are several reasons why you would consider a sale-leaseback. For example:

If you’re considering financing options for your real estate asset, you may be wondering, “Is a sale-leaseback right for me?” To answer that question, make sure to consider several variables.

First, it’s important to understand that a sale-leaseback allows you to sell your real estate without selling your business. If you plan to operate your business but no longer want to be an owner-operator, then divesting your real estate asset to raise cash can be an effective strategy. 

Second, if you’re considering selling your business, a leaseback can help you maximize profit.  For example, separating your operating business from your real estate creates more transparency, which can result in a buyer paying you fair market value for your real estate asset. In contrast, selling your business inclusive of real estate ultimately could result in a purchase price that undervalues your real estate. Plus, by negotiating a longer-term lease, a buyer may be willing to pay a higher price given a longer horizon of predictable cash flow.

Third, a leaseback can provide flexible financing if you need to pay off debt, fund operations or increase growth. Rather than sell equity or raise more debt with covenants, a leaseback can provide an alternative financing solution.

What is a sale-leaseback?

When evaluating a commercial real estate investment, it’s important to use certain financial metrics such as cap rates, or capitalization rates, to make an informed decision. 

In this detailed guide, you will learn everything you need to know
about cap rates, including:

A capitalization rate, or cap rate, is an essential financial metric used to measure the expected rate of return on a commercial real estate property. Real estate investors consider the cap rate to be the most popular financial metric used to assess the potential profitability and return profile of an investment property. 

A cap rate represents the yield or rate of return of a property on an unlevered basis, meaning the property is purchased with cash and no debt. 

To calculate the capitalization rate of a real estate investment, the cap rate formula is:

Capitalization rate = Annual net operating income / Property’s current market value

So, to calculate the cap rate, you would divide the annual net operating income, or NOI, of a property by its current market value.
Net operating income is equal to the revenue of a property less its operating expenses. However, NOI is before interest, depreciation, amortization and taxes. The market value of the property is based on the current value of the property – not the original cost of the property – based on the value of comparable properties and recent sales of comparable properties. 

For example, assume that a commercial real estate property is currently valued at $10 million and produces $500,000 of annual net operating income. Assuming you acquire the property at its current market value, the cap rate for this property would be $500,000 divided by $10 million, which equals 5%.

As an investor, you can expect to generate a 5% return based on operating cash flow relative to the price you paid to acquire the
property.

If you’re wondering what is considered a good cap rate, there is no easy answer. Cap rates vary by property, sector and geography. Cap rates for a specific property also may be influenced by the condition or specific features of the property. 

A cap rate is a useful measure of risk. Generally, the higher the cap rate, the higher the risk and reward. For example, a lower cap rate can imply a better valuation with less risk. In contrast, a higher cap rate can imply a lower return profile and higher risk. Whenever you evaluate a property, always place the cap rate in context for the specific asset within a specific market.

The general rule is that higher interest rates mean higher cap rates. While there isn’t a strict correlation or causation relationship between cap rates and interest rates, a fast rise in interest rates could lead to an increase in cap rates. 

That said, multiple other factors can impact cap rates such as local economic conditions, supply and demand, and prospects for value appreciation and rent growth.

How macroeconomic factors affect cap rates

In addition to interest rates, macroeconomic factors can impact cap rates as well. For example:

The relationship between Gross Domestic Product (GDP) Gross Domestic Product (GDP) and unemployment indicates the general health of the economy. 

When unemployment is low and GDP is high, then cap rates tend to be lower.

Conversely, when unemployment is high and GDP is low, commercial real estate properties may present higher risk. 

When inflation is high, rent growth can increase, which is a benefit to commercial real estate investors. In some cases, higher rent growth acceleration can increase Net Operating Income (NOI) and offset the impact of higher interest rates and inflation. Conversely, when the economy slows, rent growth can slow and cap rates can increase. 

High demand for a commercial real estate property can lead to lower cap rates. For example, a commercial property situated in the city center close to employment hubs, public transportation, and cultural and entertainment attractions can increase demand. In contrast, properties located farther from the city center without accessible public transportation or employment centers generally have higher cap rates. Why? These properties tend to have unstable demand, which can mean fluctuating occupancy, higher turnover and lower NOI.

While cap rates are a helpful investment metric, they also have several limitations, including:

What is a cap rate?

When evaluating commercial real estate investments, it’s important to use both qualitative and quantitative metrics. Qualitative metrics, such as market overview and property characteristics, are a helpful starting point when buying or selling a property. Quantitative metrics provide insights into operating performance, valuation and transactions. 

Equity multiples are one of the most helpful quantitative metrics to compare and evaluate commercial real estate transactions. Combined with Internal Rate of Return (IRR) and Cap Rates, equity multiples help buyers, sellers and brokers determine the best real estate investments.

In this article, you will learn all about equity multiples, including:

Equity multiple: key advantages and disadvantages

Internal Rate of Return: combine with equity multiples

In commercial real estate investing, an equity multiple is defined as:

Equity Multiple = Total Cash Distributions / Total Equity Invested

An investor should think of an equity multiple as how much money an investor can earn based on their initial investment. For example, an equity multiple of 3.0x means that an investor would earn $3 for every $1 invested in a commercial real estate deal.

An equity multiple greater than 1.0x means an investor earns more money than the investor’s initial investment. In contrast, an equity multiple less than 1.0x means an investor loses money on the investment.

If your equity multiple < 1.0x, you will lose money

If your equity multiple = 1.0x, you will break even

If your equity multiple > 1.0x, you will make money

An equity multiple compares the total equity invested into a real estate transaction with the total dollars generated from that same transaction.

Now that you know the definition of an equity multiple, here’s how to calculate an equity multiple.

For reference, here is the formula for an equity multiple: 

Example 1: An investor acquires a commercial real estate property with a $200,000 equity investment. The investor later sells the property for $400,000. Calculate the equity multiple.

Example 2: An investor acquires a commercial real estate property with a $200,000 equity investment. The investor later sells the property for $100,000. Calculate the equity multiple.

Example 3: In addition to an initial investment, let’s include ongoing, annual net operating income to determine how it impacts the overall equity multiple. Let’s assume that an investor acquires a commercial real estate investment property with a $100,000 investment. That investment property generates $10,000 a year in net operating income. After five years, the investor sells the property for $200,000. What is the equity multiple?

Example 4: How does leverage affect an equity multiple? Leverage can increase investment returns for successful investments (but prove costly on unsuccessful deals). Let’s assume that an investor acquires a commercial real estate investment property with a $100,000 investment. To finance the $100,000 investment, an investor paid $75,000 of equity and $25,000 of debt. That investment property generates $10,000 a year in net operating income. The annual interest payments are $1,500. After five years, the investor sells the property for $200,000. What is the equity multiple?

There are multiple advantages and disadvantages of using an equity multiple. For example:

Internal Rate of Return (IRR) is a useful metric in commercial real estate investing because it captures both financial returns and the time value of money. IRR captures the annual rate of return expressed as a percentage while also accounting for the duration of an investment. 

In contrast, an equity multiple doesn’t account for the time of value of money. So, the equity multiple would be the same whether you owned an investment for 1 year or 10 years. An investor would prefer to own an investment for one year rather than 10 years if the investor could achieve the same returns. 

For example, if the IRR of an investment opportunity is 15%, then an investor can expect a 15% return each year.

Start with a cash flow analysis of the investment opportunity by modeling the free cash flow in each year beginning with the initial investment and ending with the sale year. Then, discount those cash flows by the weighted average cost of capital (WACC) back to the present day. IRR is the discount rate at which the net present value (NPV) equals zero.

Once you have an IRR for one investment, you can compare the IRR for this investment with other future and past investments to benchmark whether this investment meets your required investment returns. 

One major disadvantage of IRR is the discount rate assumed. A higher discount rate will result in a lower IRR. In contrast, a lower discount rate will result in a higher IRR. 

Since the discount rate can be subjective, an investor should be careful to understand the underlying assumptions in any discounted cash flow analysis. Similarly, an investor should ensure that the free cash flows generated in each year accurately represent the revenues and expenses of the transaction. 

Buyers, sellers and brokers should use multiple financial metrics when evaluating a commercial real estate opportunity. By combining equity multiples and IRR – plus other investment metrics such as Cap Rates – an investor can gain a fuller picture of the total investment before deploying capital.

How To Use Equity Multiples For Commercial Real Estate Investing

If you own commercial real estate, you may be wondering how inflation impacts real estate.

Commercial real estate is one of the best asset classes to hedge against inflation. In periods of high inflation, commercial real estate provides both stable, predictable cash flow and the ability to increase rent. Over the past 45 years, commercial real estate has outperformed inflation nearly 90% of the time .

Over the past several years, inflation has soared due to the Covid pandemic, supply chain constraints, high commodity prices and global conflict. Every real estate owner and investor should understand inflation, interest rates and pricing to make more informed decisions about commercial real estate ownership.

In this article, we will discuss how inflation impacts real estate, including:

Inflation is the increase in the price of goods throughout the economy, which hurts the purchasing power of consumers and businesses. Purchasing power refers to how many goods an services a buyer can purchase. When the price of goods and services increases, purchasing power decreases.

For example, a slice of pizza cost $0.15 in 1950. Today, a slice of pizza can cost $3.00. Over time, the purchasing power of a single dollar has declined, which means consumers can buy less pizza with the same amount of money. When prices increase across the economy (and not only for a single product), inflation is typically the cause.

Normal inflation is considered 2%. However, during the 1970s, inflation soared higher than 10%.

The U.S. Bureau of Labor Statistics publishes the Consumer Price Index (CPI), which measures the monthly change in prices that consumers pay out of pocket for 80,000 goods such as food, fuel and clothing and services such as healthcare, college, preschool and daycare. The Federal Reserve uses CPI, which captures what households are buying, as the most reliable indicator of inflation.

The Personal Consumption Expenditures Price Index (PCE) tracks all goods and services that consumers buy, not only out of pocket purchases. Therefore, while the CPI price index tracks what consumers are purchasing, the PCE price index follows what businesses are selling.

Inflation affects both demand and supply. When fewer consumers can afford to purchase real estate, for example, rental demand increases. With heightened demand, a commercial real estate owner could increase rent to generate more cash flow. Similarly, higher prices for materials and labor, along with higher interest rates, could make it more expensive for real estate developers t build fewer properties. As a result, overall supply decreases, while the value of existing properties increases.

There are two primary types of inflation: demand-pull inflation and cost-push inflation.

 Demand-pull inflation happens when the demand for goods and services exceeds supply. An increase in money supply and available credit can increase demand for good and services. However, if there isn’t enough production capacity to meet demand, prices will increase.

 Cost-push inflation occurs when the input cost of goods and services increases the total cost of goods and services. For example, if construction costs or commodity costs are higher, a company may pass on the cost of those goods and services to the consumer. Companies offset the cost of inflation by charging higher prices.

There are several causes of inflation, which can result in higher prices for consumers and businesses. 

 When a central bank such as the Federal Reserve increases the money supply – such as through economic stimulus spending – the value of money declines.

 A disruption in the supply chain could increase inflation. When supply is limited, demand increases and therefore prices can increase too. A labor strike or natural disaster are two examples that can cause a supply chain disruption (supply shock).

 If borrowing costs are low and there is ample supply of credit, consumers can fuel a stock market rally (and make stocks more expensive) or outbid each other for a home (which increase home prices). This is called a demand shock.

Periods of high inflation can provide strong tailwinds for commercial real estate investors. An inflationary macroeconomic environment can increase cap rates and real estate prices, hel maximize net operating income, and raise property values.

There are several ways in which inflation affects real estate:

 Real estate is an income-producing asset. When investors purchase commercial real estate, they seek properties that will generate a yield above the rate of inflation.

Landlords can increase rent during period of inflation. Why? Rent represents revenue, and revenue is used to pay for operating expenses, the mortgage, property taxes and insurance. If any or all of these expenses are higher, landlords can justify increasing rent to cover their costs.

 When a central bank prints more money, the value of existing homes increases. With more money and limited supply, each individual property becomes more valuable.

 When inflation is high, construction costs typically become more expensive. This includes materials such as lumber, electrical wiring, insulation, sheetrock, plumbing and appliances. Homebuilders and investors typically pass on higher construction costs to real estate buyers.

How to use real estate to hedge inflation

Investors can use real estate as an inflation hedge. Why? When there is high inflation, real estate prices rise. Real estate investors can use real estate to hedge inflation in several ways, including:

When construction costs are higher, for example, real estate owners can pass on higher costs to tenants or other real estate investors.

 Multifamily investors can increase rents to cover costs.

Real estate has intrinsic value because supply is limited in certain geographies such as urban centers. Investors can benefit from increased assest values when there is limited supply.

Real estate can produce recurring income over time, which can increase its value.

How inflation impacts real estate

The recent failures of SVB and Signature Bank has caused some investors to question the viability of regional banks. However, before the second and third largest bank failures in history, capital markets conditions and loan portfolios had been deteriorating. A new 

 from MSCI characterizes the state of real estate capital markets as a continuing trend more than an “unexpected shock.”

1. Capital lows declined prior to regional bank failures

Prior to the collapse of SVB and Signature Bank, capital flows declined in the second half of 2022 to $842 billion compared with $1.2 trillion during the same period in 2021, a 30% year-over-year decline. This statistic includes property acquisitions, refinancings and construction loans. What drove this decline in capital flows? Property acquisitions dropped 44% and refinancings dipped 23%.  

2. Sales volumes have dropped precipitously

In February 2023, total investment sales volume declined 51% year-over-year to $26.9 billion. For the 12 months ending in February 2023, investment sales declined by 25% to $683 million. Why? Tighter financing terms and declining property prices have led to lower sales volume.

Higher interest rates increase borrowing costs for investors and operators. According to MSCI, borrowing costs on outstanding property level debt increased 4.4% in December 2022. Investors and operators haven’t experienced this level of borrowing costs since 2013.

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