Using Cap Rates For Valuation Can Be Misleading
By Karen Hanover
In a commercial real estate (CRE) discussion you will likely hear the term Capitalization Rate (Cap Rate). You will see that buyers, sellers and lenders use this term to determine the value of a property. You need to know that making an investment decision solely on Cap Rate can mislead you into making a bad investment.
Cap Rate can be considered the percentage return earned on your real estate investment during the first year of operations. It is calculated by dividing the first year Net Operating Income (NOI) by the value of the real estate which is usually expressed as the price of the property. If you're not sure what NOI means, please refer to my previous article "Determining the Value of Commercial Property."
Net Operating Income / Value of Property = Cap Rate
Cap Rate considers the first year NOI in a property. In the same property, the higher the Cap Rate, the greater the NOI from the property will be relative to the price of the property. Think about that for a second. The greater the NOI a property produces, the less money you need for a down payment. This is because lenders base their lending decisions by looking at the NOI a property produces because it is from the NOI that the debt service is paid.
In other words, when a property produces $100,000 of NOI, if the price for that property is $1,000,000, based on a 10% Cap Rate, your payment will be lower than if you had paid $2,000,000 for that property, based on a 5% Cap Rate, right? Absolutely. The payment on $1,000,000 of debt will be less than on $2,000,000. Here, NOI is the same, but the payment will differ based on price. So, for simplicity, the higher the Cap Rate, the greater the cash flows.
Cap Rates can be used as a cursory evaluation of a commercial property. Experienced investors often look at the cap rate to screen properties with low NOI relative to the price, as those properties may not produce enough cash flow to make the mortgage payment. Sellers will quote Cap Rates differently and investors must determine which type of Cap Rate is being advertised by the seller.
There is the actual Cap Rate which is based on the current NOI of the property. That means that the Cap Rate is based on actual NOI the property is currently producing and assumes that no changes to that number will occur.
Sellers will sometimes quote pro-forma or potential Cap Rate to reflect what the purchaser will receive during their first year of operations after certain changes have been made (like increased occupancy for instance). What this means is that after purchase, with certain changes made (increase in rents or decrease in expenses) the property could potentially yield a greater NOI. When the seller has quoted a pro-forma or potential Cap Rate and it is on that potential NOI that price is being determined. DON"T EVER BUY ON PROFORMA CAP RATE!
You wouldn't buy a junker car that's all beat up because after you put money into it to fix it up it will be worth more. Of course not! You would pay for the car in the condition it's in and if you fix it up and can sell it for more, you receive those profits. The same is true in real estate. If the property is only 70% occupied and therefore the income is low, you value it based on that income at 70% occupancy (again see the above referenced article for greater explanation on valuing property).
Let's say that a property could potentially generate $100,000 NOI with zero vacancy (100% leased). If the asking price is $1,000,000 for those cash flows (NOI) then the Cap Rate or return is 10%. On the other hand, let's assume that the property is actually only 80% leased and therefore only generating $80,000 NOI. If the asking price is still the same $1,000,000 for these lesser cash flows (NOI), the Cap Rate or return is only 8%.
The debt service on the $1,000,000 is the same in both examples, but the amount of NOI from which to pay that debt is less in the second example. Again, the higher the cap rate, the greater the cash flow. The greater the cash flow, the more likely the lender will make the loan.
Let's look at it another way: A property is listed for $1,000,000 and is currently 80% leased and generates $80,000 NOI. Rents are $120,000 and expenses are $40,000. Assume that the pro forma income is $100,000 per year when it's 100% leased at current rental rates and that, if rents are increased, the NOI could be $140,000. The seller could display three different Cap Rates for the same property: 1. The seller could use NOI of $80,000 per year making the Cap Rate 8%. This is the correct way to calculate the current Cap Rate. 2. The seller could use NOI of $100 and advertise a 10% Cap Rate. . 3. The sellers could use the pro forma NOI of $140,000 and advertise a Cap Rate of 14%. Although this takes NOI into consideration, it is not actual NOI but potential NOI.
As an investor, you must know which Cap Rate the seller is quoting. The returns of a CRE property come from: appreciation, cash flow, depreciation (tax write-offs), and principal reduction and the use of leverage. Despite all of this analysis of cash flow, often, the biggest chunk of your investment return comes from appreciation. This is in addition to positive cash flows! That's what makes commercial real estate so attractive.
Often properties with the greatest potential for strong appreciation are newer or in good locations and are offered at lower Cap Rates. In other words, they are priced higher. On the other hand, properties that are in poor condition, or have ground leases, are much harder to sell. As a result, a seller may try to attract buyers by advertising a higher Cap Rate. Buyer beware!
The calculation of Cap Rate only considers the first year of NOI. It considers the year after purchase and either bases it on actual or pro-forma NOI. But what if you own the property for longer than 1 year? The Cap Rate doesn't account for multiple year holdings and cash flows and you will therefore want to look at other metrics including cash on cash return and internal rate of return. Again, my article on Determining the Value of Commercial Real Estate touches upon these metrics and their usefulness in insuring a profitable and wealth building investment.
The Cap Rate should not be the only factor considered to determine whether to buy and how much to pay for a property but it is a good way to quickly weed out investments not meeting the investor's criteria or to quickly qualify investments that warrant further analysis.
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Karen Hanover is well known as a Certified Commercial Real Estate Advisor, President of the National Apartment Investors Association, Chairman of the National Commercial Real Estate Advisory Board and Senior Instructor for both the Self Storage Education Institute and the Apartments Education Institute.
As a CCIM Candidate, a highly prestigious designation, often called the "Ph.D. of commercial real estate" Karen works as a busy commercial real estate agent with Marcus and Millichap one of the nation's largest and most highly regarded commercial brokerage firms.
Sought by industry insiders for their toughest deals, Karen has helped thousands to create wealth in commercial real estate with less risk even in today's uncertain economy.
Karen founded the Commercial Investment Education Institute which provides educational instruction for investors on multiple subjects including apartments, self storage, office buildings, retail centers, mobile home parks and more. Her courses are taught in a friendly and easy to understand manner.
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