The following is a transcription of the video above:
Hey, welcome to Whiteboard Wednesdays. I, as always, am Kyle Schrader, this is my friend Jeff Rizer We're here today to dip our toes into the commercial world and talk about the basic formula for commercial real estate valuation, which is the IRV formula: income, rate, and value. So what is it?
So one thing quickly about Seaport is the way we separate ourselves is marketing, research, and valuation. And one of the tools we use is this IRV formula. So with a lot of like uncertainty in the markets, one of the things that I think and what a lot of reports show is that commercial real estate is a great investment, even though interest rates are continuing to rise.
The three-year outlook on commercial real estate looks still really strong. So if you're a new investor or maybe or seasoned investor and you're looking to jump into commercial real estate, maybe you're trying to find that first two-family, maybe trying to find some office space. It's really important to use this formula to try to figure out the true value of a property and to see if it's the right investment for your investment style.
So the first part of this is knowing income, knowing the rate, which is a cap rate, which is typically your return on investments, and understanding the true value of an actual property. There are three different formulas that we use to come up with these three things here. Income, rate, and valuation. The first one we’re going to come up with is the actual rate.
So cap rate is your ROI’s. So, it would be what is the percentage of your investment that you're making every year annually? So to figure that out, we're going to use an example where we paid $300,000 for the property - that's how much we have invested. Our annual income on it is $21,000. So it's pretty simple.
You just divide the income and value. You come up with 7% capitalization rate. So again, that's your ROI. Your return on investment for that property would be 7% annual.
So once you know the cap rate, you can figure out a couple of these other formulas as well. So if you're trying to figure out the true value of a property, somebody gives you information such as the net operating income, which is your gross income minus your expenses, equals a net operating income. And they tell you it's performing at a 7% cap rate where you can figure out what the value of that property would be and you can figure out if that's going to be a right investment for you.
So again, you take that income, which we know is $21,000 net operating income. We divide it by 7%, which is the rate that they're telling you the property is performing. And we come up with a valuation of $300,000. It's also important to understand when you’re dealing with cap rates, understanding the average cap rate for the particular property that you're looking for in the particular area that you're looking for, because it can change based on state location, type of properties, etc..
So understanding cap rates are going to be really important. And then if you're trying to figure out the actual income the property is producing, again, if somebody is giving you the information or the listing shows that it is performing at a 7% cap rate and they're trying to sell the property at $300,000, well, you can basically multiply the rates, times the value that they're telling you or they’re trying to sell the property for.
It is going to give you the net operating income. These numbers should match up and allow you to make a determination if this property is going to be a good investment for you.
Right. And this would just be the first step of the process. You would do a ton of due diligence afterward. But just to get started, as long as you have two of these numbers, you can figure out all of them.
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