When investors are selling a commercial property, they are really selling a stream of
income. Valuing this stream of income requires two factors to be considered. First,
one must quantify the stream of income itself, and secondly, one must determine the risk
associated with that stream of income.
When investors refer to the stream of income, what exactly are they talking about?
It is possible that this refers to net income. Net income is a residual, resulting from taking
all legitimate tax-deductible expenses from revenue and then subtracting the required tax
from that sum.
As a consequence, some analysts prefer to use earnings before interest and taxes
(EBIT) as a measure of income. This allows a focus on the purely business aspect of the
property. The calculation of EBIT is closely related to that of net operating profits after
taxes (NOPAT). NOPAT is basically EBIT after taxes.
The sum of net income and depreciation is typically referred to cash flow. Cash flow
is probably the most commonly used measure of income after net income. Cash
flow should probably be used more commonly than net income as a measure of income
because it makes greater economic sense.
An additional issue with respect to income is its level. We generally know a lot
about income in the present, but less about income in the future. When it is said that the
value of the property depends on the income it can generate the reference is to income
now and in the future. In many situations, future income can reasonably be expected to
grow. In some circumstances, decline is possible. The future level of income can be a
very important element in determining income.
The second element (after determining income) in determining value is determining
the risk associated with that value. Discounting that income to its present value explicitly
quantifies the risk associated with income. ---See P29
The future is always hard to predict. One way to deal with the risk of the unknown is
to increase the discount rate to reflect that risk.
Another variation of equation (1.1) commonly encountered is where future income is
likely to grow. ----See P30
Equation (1.4) is the most commonly used framework to determine value. That is,
the value of a commercial real estate property depends on how much income it will
generate, the appropriate rate at which that income should be discounted, and how much
that future is likely to grow in the future.
Overextended Borrowing
Leverage increases the potential return on a project, while at the same time increasing
the risk associated with that project.. It is a matter of balance and trade-off
Management Expertise Required
the commercial real estate
investor is going to need to be involved with searching for the project,
evaluating the project, financing the project, and (if acquired) managing
the project.
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