I read an informative article written in a KW Commercial online forum this week discussing “Cap Rates”. The forum where this article was posted encourages comments from other KW Commercial Brokers. My opinion is that we all gain more truth in our perspectives by engaging regularly in these types of conversations/discussions with other seasoned brokers from other parts the country. A foolish man or woman is one who thinks that he/she knows it all. Only through learning from others can we increase our wisdom. Real truth lies somewhere in the middle of multiple opinions. Several KW Commercial brokers from different markets provided excellent feedback in the discussion forum of this article regarding how they define “cap rates”…when determining commercial real estate value. Some of the brokers felt that commercial real estate value, as defined by cap rates, should be based on future income. Others felt like commercial real estate value should be defined based on current income. A few other brokers felt like commercial real estate value should be based on the past income through a historical perspective. Before we jump into how I prefer to define commercial real estate value (please understand that every deal is different) relating to cap rates, let’s discuss “what a cap rate is” and cover the formula used to determine capitalization rate (commonly referred to as “Cap Rate”).
“Cap rate” is a common commercial real estate value tool/term. In commercial real estate, an “income” approach typically carries more weight with appraisers than a price per square foot approach when trying to determine commercial real estate value. Residential real estate appraisers more regularly follow a price per square foot method in determining value. My opinion is that the incredibly more detailed tracking of sales comparables in residential real estate through systems like MLS (Multiple Listing Service) allows the appraiser to own the data to properly complete this type of a valuation study. The more difficult nature of producing comps (sale comparables)…the much more sophisticated investors/owners…and many other factors contribute to the reasoning for “Cap rates” being so important to commercial real estate value. A cap rate is the before tax cash on cash return that an investor would earn if he or she purchased the asset without debt. A cap rate (short for “capitalization rate”) can be determined by dividing the Net Operating Income (NOI) of the property by the purchase price.
For example, if the NOI is $100,000 per year (this asset would bring in $8,333.33 in “net” monthly income) and the property was going to be sold at $1,333,333.33, then we would have a 7.5% capitalization rate or it could commonly be called a “7.5 cap” deal. ($100,000.00/$1,333,333.33 = 0.075).
In additional to being used to determine a return for a cash investor, “Cap Rates” are mainly used to understand if a particular asset is in line with “market cap rates” (commercial real estate value)...so that a buyer can understand if he or she is paying too much or too little for an asset. The major dilemma when discussing “cap rates” regarding valuation is that this is a difficult/moving “target” to shoot at. Two different appraisers or two different commercial real estate brokers in the same market could have dramatically different opinions of commercial real estate value. This is largely why forging relationships with CRE appraisers and CRE brokers that “close” many transactions in your product type are important, so that you can better understand how the comps (what has actually sold)…determine a particular property’s commercial real estate value relating to cap rate.
Much like the definition of a “shell space” (cold shell, warm shell, raw shell, etc)…cap rates seem to have different definitions regarding commercial real estate value…depending on who you are talking to and their opinion of “what NOI to use” (cap rate formula is clear). Whether the presenter’s opinion of what NOI (Net Operating Income) to use is right or wrong…doesn’t really matter. What matters is understanding the audience’s perspective and presenting data in a manner that helps them to make an informed decision. Most of the investors we work with are tired of reviewing deals priced based on future/unknown NOI’s. They are more interested in knowing the “real numbers”. By “real numbers”, I mean income that can clearly be extracted from the current lease language or from escalations clearly written in current leases (and real expenses that come from property bills). Proformas are great tools to understand potential upside/future value…but the reality is that too many CRE deals are priced/marketed based on the proforma NOI. If an investor is buying an asset with potential upside, he or she is taking the risk and financial burden of having to EARN the upside. If the property was worth the numbers generated in the proforma today…then why hasn’t the current owner achieved the projected NOI? Does the current owner lack the capital to make improvements or the leasing team needed to fill up the asset…to produce the proforma NOI? I create proformas every day to help clients understand potential income (I am pretty conservative). The “spread” between the proforma…the “real” income that a property produces now…and our opinion of the potential of bridging this gap (capital improvements, new tenants, rent increases, etc)…is how we help our clients determine if an income producing asset makes sense to acquire. My proforma should define potential future commercial real estate value…not what the asset is worth today. My opinion is that the current property income should be used to determine the commercial real estate value today.
Moving forward…it’s still up to us humans…to determine which income stream to use for our analysis when determining commercial real estate value.
Solid information in…solid information out. Garbage in…garbage out.
See below for helpful Commercial Real Estate Value links: