Commercial real estate is an important investment asset class that provides stable income and diversification benefits for many investors. The past 20 years have seen a significant increase in allocations to both public and private commercial real estate. However, commercial properties have unique characteristics like high value per unit, management intensity, illiquidity etc that require specialized analysis. This article reviews key considerations around commercial real estate investment sales, including property valuation approaches, due diligence factors, and risks that impact returns.
Income capitalization and discounted cash flow are two main valuation methods for commercial properties
When valuing commercial real estate, appraisers commonly use three approaches – income capitalization, discounted cash flows, and sales comparison. The income approaches rely on the property’s net operating income and expected growth rates to estimate value. Capitalization directly capitalizes the NOI by an overall rate, while DCF methods discount projected future cash flows. The sales comparison approach looks at prices of comparable properties. For income-producing properties, income methods are given the most weight.
Critical due diligence items include leases, operations, environmental and structural factors
Before acquiring commercial property, investors conduct due diligence to identify risks that may impact returns. This involves carefully reviewing all major tenant leases and analyzing factors like length, renewal options, sales thresholds for percentage rent etc. Operating expenses are checked to see if owner or tenant bears the risk. Environmental assessments and engineering inspections assess potential problems. Liens, title contingencies, property tax issues also must be cleared.
Key risk factors include property market cycles, capital availability, information transparency and management expertise
Commercial real estate has risks related to the property market cycle, which on average lasts about 17-18 years. New supply entering when demand declines can lead to lower occupancy and rents. Other key factors are cost and availability of debt capital, transparency of market information, unexpected inflation, demographics shifts, illiquidity etc. Management expertise in areas like lease negotiations, capital expenditure planning, positioning/repositioning etc also impacts returns.
Publicly traded REITs and REOCs allow smaller investors to access commercial real estate
Investment minimums and illiquidity associated with private equity investments in commercial property makes it hard for smaller investors to allocate capital. Public securities like REITs and REOCs provide greater liquidity, diversification and professional management. Investors should still analyze factors like occupancy rates, lease expirations, tenant credit quality, leverage, FFO/AFFO etc while valuating them.
Commercial property valuation relies on income approaches like direct capitalization and DCF models. Due diligence and assessing risk factors related to property market cycles are key for equity investors. Publicly traded REITs allow smaller investors to access commercial real estate with liquidity and diversification.