How to Value Commercial Real Estate: Cap Rate vs. Return on Cost
Numerous investors inquire about the capitalization rate (cap rate) at which we acquired a property. The issue is straightforward, but the solution is complex since real estate valuation cannot be reduced to a single statistic. We have bought properties with negative capitalization rates and passed on others with capitalization rates above 15 percent.
What is the Capitalization Rate?
Considering the cost of upgrades and financing, a cap rate is the rate of return you may expect from a property during the first year of ownership. Consider the capitalization rate of the dividend one would get in the first year if the property was purchased with cash.
Calculating the capitalization rate by dividing the property’s Net Operating Income (NOI), which is the revenue less the operating expenditures. For instance, if a property earns $500,000 in NOI in the first year of ownership and is sold for $8,000,000, the first cap rate is 6.25 percent ($500,000 divided by $8,000,000).
A cap rate depicts a moment in time. In certain instances, the cap rate is a “trailing cap rate,” which reflects the property’s NOI for the previous 12 months. In other circumstances, the cost of capital is an “initial” or “going-in” cap rate, representing the expected NOI for the first year of ownership. It is essential to understand this since the trailing cap rate may be significantly different from the initial cap rate.
For example, suppose there is a forecasted change in property revenues (such as an increase or decrease in tenancy or a boost in rental rates due to refurbishments) or expenditure (such as increases and decreases in property taxes or changes in operating expenses). In that case, the cap rate is not a reliable indicator of value.
Capitalization rates are highly impacted by the anticipated future growth of the underlying NOI, the tenant’s creditworthiness, the contractual duration of the leases, and the liquidity of the investment market. Global investors are vying for the restricted number of assets available in the critical coastal markets of the United States and other international capitals such as London, Tokyo, and Sydney.
Consequently, they are all regarded as exceptionally liquid investment markets, and investor demand exerts upward price pressure, resulting in lower cap rates. Comparatively to poorer fundamentals, these markets tend to have strong economic growth drivers that allow owners to raise rents.
For instance, a property with a 4 percent cap rate in New York might boost its yield to 6 percent to 8 percent and rise significantly in value if market rent growth increases were high. In contrast, in markets such as Toledo, Ohio, where liquidity and economic growth prospects are low, investors must ensure that a more significant portion of their return comes from the yield, as the likelihood of value appreciation is low, which may result in these assets selling at a cap rate of 12 percent.
When to Use a Capitalization Rate
For stable properties with reliable revenue sources, the cap rate statistic may serve as a valuable evaluative tool to compare prospects. Keeping all other factors equal, a Walgreens property with a 30-year lease in Chicago will attract a comparable cap rate as a Walgreens site in Miami. The investor in this scenario is less concerned with the real property than with Walgreens’ creditworthiness and ability to adhere to the lease agreements for the whole 30-year period.
This investment is more similar to a bond since the owner is purchasing a predictable 30-year income stream; hence, cap rates are usually lower (in the range of 5.0 to 6.0 percent) and virtually entirely dependent on the tenant’s credit rating.
Cap Rate Restrictions
Due to the unpredictability of the underlying cash flows, the capitalization rate is primarily meaningless for multitenant projects, particularly those in which many value-added enhancements are made.
For instance, a 30%-occupied office building may have a negative NOI since its revenues are inadequate to cover its running expenditures, resulting in a negative cap rate. Nonetheless, if the owner stabilized the property via investing, this may be an extraordinary opportunity. We use a particular statistic known as Return on Cost to determine the worth of these possibilities.
What is Return on Investment?
Return on cost is a forward-looking capitalization rate; it considers the expenses required to stabilize the property and the future NOI after the property is stabilized. It is determined by dividing the purchase price by the expected NOI. We utilize a return on the cost to analyze whether we may produce a more significant income stream than if we acquired a stable asset now.
For instance, if completely restored, stabilized buildings are selling at a cap rate of 6 percent today, we would get $1.2 million in NOI for $20 million. If we bought a value-added opportunity for $18 million that requires an additional $2 million in refurbishment funds, the total cost would be $20 million. Assume the property has been mismanaged, is only 80 percent occupied, and has a net operating income of $750,000.
However, after the value-add business strategy is implemented, the property’s NOI may climb to $1.5 million in three years. This property’s return on investment would be 7.5% ($1.5 million divided by $20 million). We now have $1.5 million in income, and if we split that by the stable cap rate of 6%, the property is currently valued at $25 million, representing significant value growth compared to the acquisition of the stabilized asset.
The cap rate is among the numerous factors investors should consider when evaluating a real estate transaction. To understand how to utilize the cap rate to value real estate, it is essential to grasp what it represents and its constraints. Notably, the cap rate should not be substituted for the optimum approach for valuing real estate: discounted cash flow analysis.
Real estate valuation is both an art and a science; the most accurate approaches involve a mix of original and trailing cap rates, projections for the cap rate upon sale to the next buyer, and return on cost. Using cap rates in isolation might have negative results.
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