When you purchase commercial real estate there are several methods to help you arrive at a valuation.
(article continues below)
One of the most common and least understood methods involves using a cap rate. Unfortunately, most people do not understand what a cap rate is, where it comes from, and how to appropriately use it. Read ahead to fill in the gaps in your cap rate knowledge. It will help you figure out exactly what your real estate broker has been saying.
Valuation Using Cap Rates
Using a cap rate to value a commercial property is typically referred to as a "back of the envelope" method. The basic concept is simple, and has two steps. First, you calculate the net operating income (NOI) that the project under consideration will produce in the next year. If you are valuing a property with NNN leases this is a very simple calculation.
Second, you take that net operating income and divide it by a cap rate to get the value of the property. The cap rate is a percentage. For instance, an 8 cap is 8% or .08. Thus, a project with $200,000 of NOI will be worth $2,500,000 using an 8 cap.
What Does The Cap Rate Indicate?
If you look at the cap rate equation (Value or Purchase Price = NOI / cap rate) you can see that the cap rate is really a simple return. In other words, the individual in the example above would be paying $2.5 million for the building and would receive an 8% annual return. In other words, if you were willing to accept a lower return on your money (say 4%) then you would buy the building at a 4 cap, and the price would be $5 million ($200,000 / .04 = $5,000,000).
Deriving a Cap Rate
In mathematical terms, the cap rate is equal to the interest rate minus expected growth plus a risk premium. In other words, there is a certain risk free interest rate that you can achieve without buying real estate. The 10-Year Treasury is a basic example of this. However, for buying real estate you should get a certain risk premium in addition to that. Finally, any expected growth in the market should be subtracted out of the cap rate.
Here's an example of how the 8 cap above could have been derived. Let's say the 10-Year Treasury is at approximately 4%. This building is in a fairly risky market, Las Vegas, so the risk premium is somewhere around 6%. However, Las Vegas expects 2% growth in the commercial market in the next year. So 4 plus 6 minus 2 equals 8. There is your cap rate of 8%.
Cap Rate Variations Explained
Looking closely at the formula for a cap rate helps explain why you see variations across markets. Typically you see much lower cap rates in core markets (New York City, San Francisco, Chicago, and similar closed urban areas) while you see very high cap rates in non-core markets. The reason for this is a combination of expected growth and risk. For most investors a property in midtown Manhattan has very low risk. It's not like the demand for office space in Manhattan will disappear in the next ten years. In addition, the likelihood of rent growth is high because it is a built-in core market with little room for expansion.
On the flip side, an office building on the edge of farmland in Iowa is very easy to replace next door, which limits the opportunities for growth and presents great risks as other developers could over-supply the marketplace.
Remember that cap rates provide a simple snapshot view only. For a detailed and nuanced perspective you will want to take a look on a discounted cash flow (DCF) basis. But understanding what the cap rate is and where it comes from will help you to take a quick look at investment opportunities without wasting time on a property listed with an unrealistic cap rate.