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An Explanation of Cap Rates


Colin Brechbill - Sunday, March 25, 2012

Last week one of our clients told me that he would like to raise some cash to pay his impending federal tax bill. He owns quite a few properties - most are income producing, some land, some warehouses, some offices - and all very marketable.  This gentleman is a very logical seller (and logical buyer, for that matter). He knows what motivates him so he knows what motivates buyers. He keeps detailed records, copies of invoices, leases, and tax records, etc.  When he tells me the net operating income, I know the number will be accurate.

We did a full analysis of his portfolio and put two of his commercial properties on the market.

In the commercial real estate market savvy investors use a capitalization rate (Cap Rate) to do an acid test of a properties worth.  Put simply, the cap rate is a measure of the return a property's net operating income will generate as a percentage of its cost.  A property that generates $100,000 worth of income from rents after paying for all expenses to own and manage the property, but before paying debt service would sell at a $1,000,000 price if the cap rate was 10%. ($100,000/10%=$1,000,000)  Buyers prospecting for good properties are looking for cap rates of around 7 to 8% these days; sometimes less from properties with very long leases and with AAA tenants; and sometimes higher CAP rates from older properties with shorter leases.  If a property has a net operating income of $100,000 and a buyer is willing to accept, say a 7% CAP rate he would pay $1,428,571 for the property. ($100,000/7%).  If on the other hand he needed to get an 8% CAP rate he would pay only $1.250,00; at 9% the price would have to would be $1,111,111. ($100,000/9%) 

For the same income property, as the price goes down the cap rate goes up. As the price goes up the cap rate goes down.

According to textbook definitions (Greer and Farrell, 1992), the NOI used for the estimation of the cap rate, or the overall capitalization rate, is the projected net operating income of the property during the first year following its acquisition. Thus, taking into account the different time periods that the components of the cap rate formula refer to, the correct mathematical expression for this formula is :

CRt = NOIt+1 / TPt

Where:
CR= Cap Rate
TP= Transaction Price
t = year t, during which the transaction occurs
t+1= year t+1

The cap rate actually represents the income return to the investor that is acquiring a property. For example, the cap rate of a transaction involving a property expected to produce an NOI of $100,000 in the first year of its holding period and is sold for $1 million, is:

Cap Rate = 100,000/1,000,000 = 0.10 = 10%

The estimated cap rate represents the income return in the first year of the holding period and that is why it is often referred to as initial yield.

When I started buying commercial income properties in Fort Myers, I remember telling the agent that I did not buy by cap rate.  This was because that most cap rates advertised were bogus.(Unfortunately this is still often the case) The agents or sellers often fail to include many expenses in their pro-formas (a pro-forma is a reconstructed Profit and Loss statement) that needed to be there - such as reserves for long term replacement items such as driveways and roofs; they may leave off vacancy and credit losses; and they may forget to include management fees.   Because of these omissions in many pro-formas, as well as the difficulty and inaccuracy of getting accurate lease and expense information, many commercial buyers will make an offer at a given CAP rate. Then during the due diligence period will make every effort to discover what the true net operating income is. Most commercial offers are contingent on a 30 to 90 day due diligence period during which the buyer will have inspections and audits completed.

One reason a buyer will pay a price that offers a lower CAP rate for a property is for it's upside potential.  If the price per square foot for example is well below replacement cost, or the rents are well below market, or major repairs have been made on key items like roofs and air-conditioning; the buyer may have reason to believe that he can soon lift the cap rate by increasing rents or lowering operating expenses.  A good agent will take all this into consideration when advising a buyer client on how to make his offer and a seller client what price to ask 

The price a seller asks is also guided a great deal by his motivation.  In my client's case for example, he needs to sell one of his properties at a CAP rate attractive to the buyer in order to effect a rapid closing to raise cash to pay his taxes. (He is also not bashful about letting the buyers know this either). In fact, I have been telling prospects that once one of the properties is under solid contract, the other properties from this client will see either a removal from market or a price increase. Why?  Because his motivation has changed.

So what is the right price to pay for a commercial property? Today we just talked about CAP rates.  The right price to pay is the price that will give you the return on your investment that will satisfy both your short terms objectives and long range goals.  We must take into consideration your cost of money and your opportunity cost (What else you could do with that money)

If your cost of money is 9% would it make sense to buy a property with a 7% CAP rate? Yes, but only IF there was a good prospect for increasing the CAP rate in the short and long term, there is a good future property appreciation anticipated (CAP  rates ignore appreciation), or the investment met other objectives.  A good commercial agent will help you analyze the income, the appreciation, and the tax benefits of ownership, along with your attorney and tax advisers.

If you have what I call "very patient money" and are able to ride out cycles that are inevitable in our market, you may be willing to buy at a low cap rate because the investment simply beats out other things you could do with your money. 

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