Today, I’m going to explain how losing money on commercial real estate makes perfect sense. Hear me out.
One of the primary methods used by commercial appraisers to value many types of commercial real estate is the ‘income approach’. The income approach is an attempt to quantify how much a purchaser or investor would be willing to pay for the future benefits of owning commercial real estate. Basically, these benefits consist of annual income generated by the property and also any expected profit (or loss) when the property is resold.
To clarify, these benefits consist of:
- Annual Cash Flows (The Net Operating Income)
- Profit Upon Resale (The Reversion)
Most often, commercial buildings are purchased with a combination of funds from an investors’ own pocket and funds borrowed from a bank or other lending institution. When the annual cost of the loan payment exceeds the annual cash flow from the property, the result is a a negative annual cash flow. I’m seeing this more and more these days for certain types of property – situations where borrowers are willing to accept a negative annual cash flow.
But how can this make sense?
Think of it this way: Those who attend college are in the exact same position. They’re willing to accept a negative annual cash flow (in the form of tuition payments) in anticipation of future income benefits (in the form of a better job). When you start seeing investors who are willing to accept a negative annual cash flow, it’s a sure sign that they are expecting property values to increase and to reward them in the end.
Why am I bullish about the commercial real estate market?
Because I’m paying very close attention.
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Great article, Russell. Don’t many banks require a minimum debt coverage ratio of 1.20? I don’t remember where I got that from, but if that’s so, wouldn’t they require additional collateral?
Thank you, Wyatt, and yes they do. I have seen a number of occasions when they over-collateralize a loan, requiring a borrower to pledge several properties to secure the loan.