Use capital rate to estimate property value

Dale Beede
Dale Beede

Any real estate appraiser will tell you there are three primary methods used to properly evaluate the appraised value of a property: the cost approach, income approach and market data approach. 

The first approach determines the cost to construct improvements on the existing parcel less any deferred maintenance or obsolescence. The market data approach looks at sales of comparable properties and attempts to value the subject property on a dollars-per-square-foot value when compared to sold comparables. In commercial real estate, brokers often refer to average sales prices for similar properties in terms of $X per square foot based on previous sales of similar properties.

For single-tenant and multiple-tenant properties with a triple net lease, the method used most often to appraise value is the income approach. This method is usually used because of its accuracy in portraying the true financial picture of the property when looking at its income and expenses.

Assume we’re placing a value on a 30,000-square-foot industrial warehouse with a small office leased to an international company. The tenant’s financial information shows they’re profitable with little or no debt and their lease won’t expire for 10 years. The company is paying $150,000 per year in rent payments of $12,500 per month. The lease calls for the tenant to pay property and personal property taxes, insurance on the structure and all maintenance. In addition, rent increases 3 percent a year. This represents a true NNN lease. The only landlord requirements are roof replacement (the roof is 5 years old) and structural repairs (the building is 5 years old and exhibits no cracking that would typically be seen if it had structural issues).

We know the net income to the prospective investor is $150,000 before income taxes and depreciation.  How do we value this investment for a prospective buyer?

Most commercial real estate brokers use the capitalization rate or “cap rate” to get a simple estimate of the building’s value. In this situation, the tenant is an international company with strong financials and 10 years remain on the existing lease. In addition, you determine the tenant is in a business that should see many years of growth. The next step is to capitalize the $150,000 a year in income based on what is standard for the area and the credit quality of the tenant. In Western Colorado, it’s common to see a single-tenant triple-net lease to a credit tenant (a public company whose financials are readily found in a Dunn & Bradstreet report) result in an investor-required cap rate of 7 percent to 8 percent.  That is, most investors purchasing this type of income stream with a quality tenant will demand a 7 percent to 8 percent yield on their investment. If we divide the $150,000 net operating income by .07 and .08 to represent the cap rate demanded, we see the subject property has a value base on the income approach of $2,142,857 to $1,875,000 respectively. That’s right, a higher cap rate demanded by an investor will result in a lower price that investor is willing to pay for the property. 

We’ve now determined the approximate value of the property for the investor. Next, the astute investor and his or her broker will determine whether or not the rent being paid is sustainable if the tenant was to suddenly go out of business and a new tenant had to be found. Additionally, a careful look must be given to the property to determine what, if any, deferred maintenance items must be addressed in the near future. Are there any plans by the city or county in which the property is located that will detrimentally affect the property? For example: Would a new highway restrict access to the property? All are important to the integrity of the investment.