Consider capitalization rates when buying
Real Estate Investors for any form of income property should consider capitalization or cap rates when making purchase, finance and valuation decisions.
In general a cap rate can be defined as the ratio of the net operating income produced by an asset to the purchase price or value of that asset. For instance if an investor purchased an office building with an annual net operating income of $70,000 for $1,000,000 that sale would result in a 7% Cap Rate to the investor. A Cap Rate that is based on the ratio of the first year of net operating income to the property purchase price is defined as the “going in” cap rate. In some instances an average cap rate for a property will be quoted. An “average cap rate” is the ratio of the average annual income over a given lease term to the purchase price. Thus “average” cap rates fail to account for the time value of money making the “going in” cap rate a more accurate definition of value. Inversely in instances where a property is un-priced an investor can apply a cap rate to the income stream to arrive at an estimate of value.
In an active market, cap rates extracted from recently completed transactions which are commonly known as Market Cap Rates can provide investors and appraisers a useful guide for determining the appropriateness of the cap rate being used to value a subject property. One should note that Market Cap Rates represent an average of numerous property transactions that can vary widely in terms of location, lease terms, tenant quality, property condition and other characteristics of value. Thus it is important to make upward or downward adjustments to Market Cap Rates when estimating the value of a given investment property. Even property types with relatively uniform characteristics such as Walgreens triple net lease properties can experience cap rate variation based on location, lease term, age, access, year of lease commencement, market demographics and other characteristics. Despite their variation long term strong credit single tenant NNN lease properties such as Walgreens can provide a baseline for determining the lower end range of commercial retail property cap rates in a given market area.
Like any investment ratio, cap rates can be misleading if they are not applied uniformly to compare properties. For instance it is not useful to compare the “going in” cap rate for one property with the “average” cap rate for another. This is because a “going in” cap rate measures the net operating income in the initial year of ownership relative to the purchase price while an “average” cap rate takes the average of what could be an annually escalated lease over five or ten year term. Both could be represented as a projected cap rate for a given property but a direct comparison between the two cap rates wouldn’t be valid.
One of the most useful attributes of the cap rate is as a quick assessment of the exit risk for a prospective investment property. Investors that purchase a property with the presumption that their “going in” cap rate will be substantially higher than the “going out” cap rate that another investor would be expected to pay upon sale should carefully consider their value add assumptions for that property. In other words any plan for achieving a higher sale price for a property without a commensurate increase in net operating income can be highly speculative because you are depending on a decrease in market cap rates over time instead of relying on the property’s operating performance.
Trends in market cap rates are also helpful in determining the overall perception of interest rate and investment risk in the real estate market place. Like other financial instruments such as bonds income properties are ultimately impacted by interest rates and investor risk premiums. When borrowing costs are low investors may accept a lower cap rate or they may increase their risk premium and continue to expect the same cap rate. Additionally as interest rates increase investors may require a higher cap rate to a maintain debt coverage or they may lower their risk premium. The chart below shows trends in national cap rate spreads for apartment, office and retail transactions over the last five years, calculated as the difference between the 12-month rolling cap rates and the 10-year Treasury yield. It appears from the chart that investors are requiring a higher spread between market interest rates and cap rates to account for long term inflation and interest rate risk.