Commercial Appreciation Over Long Haul

I am just researching commercial real estate investing as a possible future for me. One question, what is the national average for appreciation of commercial properties over time? Residential properties supposedly have a long term average appreciation rate of 6.34%, so I have read. Just wondering if such a number exists for commercial properties.

When any of you are calculating an over-all ROI for a particular commercial property, do you take appreciation into account or only the cash-on-cash return?

My view at present is that in order to do better than the stock market, I need to see something like 20% cash on cash. but cap rates I see all over seem to exclude that possibility in most cases. Maybe I'm reading the numbers wrong.

However, taking a long term appreciation into account, that would change the ROI considerably.



[ Edited by Dewdman42 on Date 12/11/2007 ]

Commercial property appreciation is almost always tried to cap rate and location. The location obviously can't be changed, but the way the market perceives can. For example, your have the "best located" strip center on the east side of town, then a Super Wal-Mart opens on the west side. Almost overnight, the new "best location" is on the west side, completely across town from your units. So you have very limited control over the location issue. On the cap rate side, you have much greater control. Make improvements to the property, get and retain quality tenants at good rent rates, and keep expenses in check.
By increasing the cap rate, you increase the value of the property, if you're good at it, you can vastly exceed the rate of return on residential properties. For example, we took a 12 unit strip center from a $44,000 NOI to 102,000 NOI in five years. With a 8 percent cap rate, the value went from 540,000 to 1,275,000. or an appreciation rate of over 25 percent per year. This is just my opinion, I'm sure other investors have their own ideas.

I understand well that the price of a commercial property at any given point in time will depend on many factors, including the cap rate(which is hugely effected by the current sub prime rate), regional economics, national economics, etc.. Different set of factors may determine the value of commercial property at any given time, but there can still be a long term average national rate of appreciation, which is what I am trying to find out.

Residential property also has regional differences effected by all of the above. Interest rates, economic conditions, regional conditions, etc..can all cause homes in an area to appreciation or depreciate, sometimes by a little, sometimes by a lot, but over many years we see an average long term appreciation of 6.34% across the nation.

Over time, is there an AVERAGE national appreciation rate that anyone has measured for commercial?

(duplicate deleted)


[ Edited by Dewdman42 on Date 12/13/2007 ]

6.34% Where did you get that number? I always understood residential real estate appreciation would track the rate of inflation at about 3% or so. I do believe that you need to beat the stock market in the long run and mid run in this business, otherwise it's not worth it. If you have any interesting websites that talk about these figures, let me know.

6% is well known as the appreciation of housing, which has far outpaced the rest of inflation by the way. I can't refer to any sources right now, but if you read around you will find them.

Anyway, does anyone know if such a number exists for commercial?

Check out this article. This will give you some insight

http://money.cnn.com/galleries/2007/real_estate/0704/gallery.stocks_v_realestate.moneymag/index.html

that's very helpful. Thanks. So it sounds like commercial will outpace residential appreciation by a percent or so. Very interesting.

The flaw in that article is that the writer is not really comparing apples to apples. He is comparing the appreciation of real estate to the appreciation to stock. But real estate returns money in more ways than that. Most people purchase real estate with the help of a bank, which means they are leveraging some of the bank's money to gain ownership. Furthermore, if the property is cash-flow positive from day one, then there is money coming in from several different places:

1 - The property is appreciating and you have leverage.
2 - The mortgage is being paid off by a tenant
3 - there may be surplus of cash flow from rents
4 - There are tax writeoffs

If you buy a piece of commercial property with 20% down at 10% cap rate....the ROI FAR out paces the measly 13% that the stock market has done.

But everyone knows that already. Right now a lot of people seem to want to sell commercial property at the 8% cap rate range, which is not very good with current interest rates what they are. However, if you factor in another 6-8% of appreciation on top of the other cash on cash return...it still may outpace the stock market.

I peg commercial re in general at a 2.5% appreciation rate. This correlates with average rent increases. Note this re appreciation rate does not directly correlate with general inflation rate or take into account changes in cap rates. If cap rates increase then you get depreciation not appreciation unless rents offset this dynamic.

[ Edited by haxton1 on Date 02/22/2008 ]

I peg commercial re in general at a 2.5% appreciation rate. This correlates with average rent increases. Note this re appreciation rate does not directly correlate with general inflation rate or take into account changes in cap rates. If cap rates decrease then you get depreciation not appreciation unless rents offset this dynamic.

There are other ROI's you aren't factoring in.

You can't just add a couple percentage points to the cap rate and call that your ROI. There are more details to consider

1 - The Cap rate is calculated from NOI which does NOT factor in the loan. Yes, if you pay 100% cash for the building, then I suppose you could add 2.5% to the cap rate you are getting when you purcahse the building to figure out the ROI, though I think there is some capital depreciation tax write offs to consider also.

2 - Most people get a loan. Depending on how much you put down, the positive cash flow will not even come close to the cap rate, whatever it is. But ideally there will be some. That represents only PART of your ROI.

3 - You also have the tenants paying off your loan for you. Each year they will be paying more and more towards your principle. That is part of your ROI.

4 - There are tax write offs associated with this investment.

5 - There is 2.5% appreciation in the market, based on rising rents, but not factoring in changing cap rates.

6 - If you make any improvements, then there will be expenses and ideally you will be able to increase the rents and increase the value also, but that is really outside the scope of the original question here, as is also the speculative consideration about changing cap rates.

When you add all of those things up, then you will arrive at a final ROI, where your investment is the down payment you made for the loan initially. However, you also need to consider that over time as the principle of the loan is paid down by your tenants, then your "investment" is increasing. In other words, any equity you hold in the property at any given time would be considered your "investment" in any given year. So for example, in the first year, you have 20% investment(your down payment). Actually a bit more because of purchase fees, etc. 10 years later after the tenants have paid off part of the principle for you, your actual investment would be higher because you would be holding more than 20% equity by then. So you would need to factor that against the various positive aspects I mentioned above to arrive at an ROI for that year. this means that if you keep the original loan in place, your ROI is actually decreasing over time. At some point it makes sense to refi and move some of that equity into another property, so that both properties will have a higher ROI.



[ Edited by Dewdman42 on Date 01/30/2008 ]

Sorry to take so long to respond-

Yes, as you observed, I was ignoring the effect of the loan- and was discussing total return.

Offhand, it seems risky to have a property with a loan at a higher interest rate than the cap rate. With a small amount down, it would appear easy to have a negative cash flow if there is vacancy.

And, as you point out, as time passes, there is more equity as the loan is paid off.

On the other hand, from an investment point of view, the going rate (at least a few months back) of 7.5% interest for loans isn't too bad of a return.

Depreciation as a tax write-off will vary by situation so each specific situation would have to be analyzed.

Also, the 2.5% appreciation is probably more than cancelled by the inflation rate-

Interesting observations
Thanks-

In our case, real estate is being used to a large degree as an investment vehicle. In general, asset diversification startegies allow for more conservative investments- one of which is paying off loans or investing in bonds, stocks, etc.

Of course depreciation is deductable, but it's usefulness depends on the tax situation and tax bracket- obviously it's more attractive for high tax brackets.

As you suggest, one needs to do a detailed analysis. We are contemplating a NNN situation which should hold down costs.

In our case 1031 exchange is almost the only viable option as the property is in a corporation (never put real estate in a corporation(!)-but that's another story)

And how are you finding these 10% cap rates? I must be missing something- I thought problem properties were at that rate.

I answered another post "Moving from Many Single Houses to Multi Unit Buildings"- he seemed content with less than 3% cap!



[ Edited by MAT3Sigma on Date 02/21/2008 ]

I think commercial is so unique that it would be hard to get a consenses of what the long term appreciation rate would be. It seems to me that every deal has it's own personal valuation.
I think people get too caught up in the cap rate to evaluate properties. Although it's an important bench mark, why would you pass up a deal say in downtown manhatten just because it has a short term cap rate of 5%...you wouldn't if you were a longterm investor because your valuation is based on foot traffic and longterm appreciation of rents. If you bought an apartment complex in Oklahoma, you might get a cap of 10%, but is that a better deal?...not necessarily. Valuation to me is dependent on so many variables I don't have to write them all down. If I had to point out one thing I would say what is your risk tolerance and exit strategy. (Sorry that's two things) You have to know these things going into the purchase in order to properly evaluate the deal.

To be conservative I would use 2% appreciation (average).
But keep local market dynamics in mind - they can be VERY different.

Interesting read here. I think investors look at ROI from all different angles.

Example: I bought land 2 years ago with a tenant that is paying me a 6% cap. Most people might say 6% is not a great deal, but I say differently

Analysis of the deal:
1) Strong Tenant with long term lease
2) No management of property required
3) No landlord expenses (NNN)
4) If the tenant goes dark, land is valuable because of the surrounding retail and car traffic

Because of the low risk and the initial demand, the rate of return is low ( 6%), however rental increases over the next 10 years put the cash on cash return at 8%. If you factor in the current appraisal the present value rate of return is 30% due to appreciation.

while no one can predict the rate of return in the future, if you want a 20 cap right out of the gate your going to have to negotiate for it upfront or raise the cash flow/rents once you acquire the property. Or you are going to have to take more risk...I.E. handle expenses and management..

The question itself is flawed.

Nobody buys the National Average Appreciation. You buy one deal. This is much more like an individual stock than the Dow Industrial average which is what they are using to calculate the "average" stock market return.

Even if you bought a Dow Mutual fund you wouldn't match the Dow return because the fund would have fees and costs which are not included in the calculated DJIA. In addition the DJIA is used because its old-- they've been calculating it for a hundred years so it looks like its giving a lot of information about long term trends.

But they tinker with it all the time so its a lot more actively managed than you might first think. Almost none of the original Dow stocks are still in the mix. US steel is gone Disney is in (just as a most recent example). So even if you bought the DJIA in the 50's and you didn't tinker with the portfolio mix every time the Dow/Jones guys change it you wouldn't have the "average" stock market return-- you'd actually be pretty much bust.

The point is that the question implies that I can buy something (stock, real estate, land, gold, oil, etc.) and just wait for somebody else to make them appreciate in value even if I don't think about it or manage the portfolio or the underlying asset.

THIS PREMISE IS A FALLACY, it is a fallacy in the stock market, its a fallacy in the real estate market. Left unattended the value of investments declines over time-- not increases. (this is akin to the first law of thermodynamics). Only the addition of management reverses this principle.

You can either provide that management yourself (as most of the members here do) or you can get somebody else to provide it (as if you bought a REIT or a partnership with a working partner) but thinking you will participate in the National Average (which includes the efforts of a lot of people attempting to add value all the time) is a sure-fire way to ignore all that management (work) which you or somebody else is going to have to put in.