Is Cap Rate All I Need for Valuation?
Capitalization rate is perhaps one of the most common valuation methods for commercial real estate. It is used to determine the rate of return on an investment property. The cap rate is calculated by dividing the property’s net operating income by the property’s market value, then multiplying the result by 100 to convert to a percentage.
While the cap rate is a useful tool for quick property comparisons, it should not be the only tool used to determine the profitability of an investment.
Considering this alone can lead one to obtain a property that straps their financial futures or perhaps even causes them to miss out on a prime investment opportunity.
Case Study: Misleading Numbers
Take for instance, an industrial space in Colorado Springs in which we assisted a buyer a few years ago.
At first glance, the price of this property appeared to be priced at market because the capitalization rate of 8.3% was a competitive cap rate for investment properties at the time. But there were many other similar properties with a cap rate of that or higher. So what made us determine this property was the ideal investment for our client?
This was actually a value added transaction with significant upside. And we only realized that by looking at factors beyond the cap rate. Here are other variables that we took into consideration when assisting this buyer with the acquisition of this property:
Price Per Square Foot – This property sold for approximately $47 per square foot. At the time, similar industrial properties in Colorado Springs had been selling for greater than $67 per square foot.
Rental Rates – The rental rates for this property ranged from $4.00, NNN to $5.00, NNN. This property consisted of 1,000 square foot industrial suites. Rental rates for similar suite sizes ranged from $5.75 to $7.50, NNN. Because there was a very limited supply of 1,000 SF industrial suites in Colorado Springs (and still is), we saw an opportunity for an increase in rental rates for this property to the upper end of rates at +$7.00, NNN.
Short-term Leases – Almost all of the leases in place at the property were short term, providing the opportunity for the buyer to increase the rental rates within a short period of time.
By looking at these various factors, we were able to help our client obtain a property with a good capitalization rate plus immediate value-add opportunities based upon current market conditions.
While market rates have changed dramatically since this example occurred, the principal remains the same. Market conditions, location, building condition, leverage within the deal, and future cash flows from property improvements are all factors that must be considered in tandem with a property’s cap rate.
Our clients can expect expertise in not only buying, selling and leasing your commercial property, but also in understanding the true value of your investment and the opportunities that you may be missing.