Valuation Methods in Commercial Real Estate:
One of the most common yardsticks used in commercial real estate investments is the “cap rate”, which is a shortening of “capitalization rate”. Simply put a cap rate is the basic yield that a property provides to an investor in relation to the value or purchase price of the property. As an example, if a property has a net operating income (NOI) of $100,000 per year and the selling price of the property is $1.25 million, then the cap rate would equal 8% ($100,000/$1,250,000). There is a big footnote that many may not fully realize, and that is that the cap rate isn’t going to always be the yield the investor will be achieving.
Cap rates are great for a generalized comparison of properties and trends, but in some cases they overstate the real rate of return to an investor. Typically the NOI of a property, as quoted when offered for sale, does not factor in certain landlord ownership costs, such as leasing commissions and capital investments in the building and tenant spaces (like tenant improvement allowances). This addition will reduce the NOI and subsequently reduce the cap rate. Furthermore, since cap rates are determined using only the first year’s NOI, they do not take into account the forecasted long-term performance of the investment. Since most properties are represented to the investment marketplace in the same manner, this discrepancy is perhaps not as relevant from a comparative standpoint to like properties, but it would be more relevant to other asset classes like corporate bonds or dividend paying stocks.
Besides the foregoing, the cap rate isn’t necessarily going to be the same return on investment (ROI) to an investor if the property is leveraged. So long as the interest rate is lower than the cap rate (after also taking into account the amortized principal payments in the leverage) then the leverage can substantially increase the ROI. In today’s low interest rate environment it isn’t unusual to boost the ROI from 7-8% unleveraged return to a 12-13% return, assuming a conservative level of financing (50-65%).
The range in cap rates will also differ significantly by the type of property. A very low risk land lease by a major national credit tenant, like a Walgreens or a Chase Bank, can currently see cap rates under 5%, while more risky retail or office properties with weak tenants can see cap rates double that. The risker the asset and the more uncertainty there is, then the higher the cap rate. Investors will require a greater return on investment for taking on more risk, often called a risk premium.
As real estate moves in and out of favor compared to other asset classes (such as money markets, stocks, bonds, etc), the cap rate can also change. Currently there is a significant gap between what an investor can earn in the money market or bond market compared to commercial real estate, which causes there to be an increased demand in real estate, which in turn keeps cap rates competitively low.
The biggest influence on cap rates is the overall interest rate market. There is a direct correlation between interest rate moves and cap rates in commercial real estate. If interest rates increase cap rates will likewise increase (not necessarily point for point). Rising cap rates and rising interest rates mean that valuations are dropping. The overall balancing is all part of being an “efficient” market place. An efficient market means that all information out in the world is known and accounted for by the knowing public.
Since the bottom of the market and the flow of almost interest free money by the Fed, cap rates are certainly approaching historical lows. This is an enticing time to sell for many, while still an attractive time to buy for the yield hungry investor.
Despite some limitations, cap rates still provide an incredibly useful tool to investors, allowing them to make quick assessments of properties to measure them against their investment goals and to compare them to both one another and to the market as a whole. As with any form of financial analysis, you need to take the pros and cons into account, and use multiple metrics in making your decision.
Dougall McCorkle, MBA
Sales Associate and Commercial Specialist
Premier Commerical, Inc., Licensed Real Estate Brokers
Direct: 239.213.7234
Cell: 239.860.3368
dougall@premiermail.net