Cap Rates Could Potentially Mislead You

In a commercial real estate (CRE) discussion you will likely hear the term Capitalization Rate (Cap Rate). You will see that buyers, sellers and lenders use this term to determine the value of a property. You need to know that making an investment decision solely on Cap Rate can mislead you into purchasing the wrong property.

Cap Rate can be considered the percentage return earned during the first year of operations. It is calculated by dividing the first year Net Operating Income (NOI) by the value of the real estate which is usually expressed as the price of the property.

Net Operating Income
Divided By
Value of Property
Equals
Cap Rate

Cap Rate considers the first year NOI in a property. In the same property, the higher the Cap Rate, the greater the NOI from the property will be relative to the price of the property. The greater the NOI a property produces, the less money you need for a down payment. This is because lenders base their lending decisions by looking at the NOI a property produces because it is the NOI that is the source of the cash flow that the borrow has available with which to make the payments on the loan.

In other words, when a property produces $100,000 of NOI, if the price for that property is $1,000,000, based on a 10% Cap Rate, your payment will be lower than if you had paid $2,000,000 for that property, based on a 5% Cap Rate, right? That’s easy.

Here, NOI is the same, but the payment will differ based on price. So, for simplicity, the higher the Cap Rate, the greater the cash flows.

Cap Rates can be used as a cursory evaluation of a commercial property. Experienced investors often look at the cap rate to screen out properties with low NOI relative to the price, as those properties may not produce enough cash flow to make the mortgage payment.

Sellers will quote Cap Rates differently and investors must determine which type of Cap Rate is being advertised by the seller. There is the actual Cap Rate which is based on the current NOI of the property. That means that the Cap Rate is based on actual NOI the property is currently experiencing and assumes that no changes to that number will occur.

Sellers will sometimes quote pro-forma or potential Cap Rate to reflect what the purchaser will receive during their first year of operations after certain changes have been made. What this means is that after purchase, with certain changes made (increase in rents or decrease in expenses in some manner) the property could potentially yield a greater NOI. When the seller has quoted a pro-forma or potential Cap Rate and it is on that potential NOI that price is being determined.

Let’s say that a property could potentially generate $100,000 NOI with zero vacancy (100% leased). If the asking price is $1,000,000 for those cash flows (NOI) then the Cap Rate is 10%.

On the other hand, let’s assume that the property is actually only 80% leased and therefore only generating $80,000 NOI. If the asking price is still the same $1,000,000 for these lesser cash flows (NOI), the Cap Rate or return is only 8%.

The debt service on the $1,000,000 is the same in both examples, but the amount of NOI from which to pay that debt is less in the second example. Again, the higher the cap rate, the greater the cash flow. The greater the cash flow, the more likely the lender will make the loan.

Let’s look at it another way:

A property is listed for $1,000,000 and is currently 80% leased and generates $80,000 NOI. Rents are $120,000 and expenses are $40,000. Assume that the pro forma income is $100,000 per year when it’s 100 %t leased at current rental rates and that, if rents are increased, the NOI could be $140,000. The seller could display three different Cap Rates for the same property:

1. The seller could use NOI of $80,000 per year making the Cap Rate 8%. This is the correct way to calculate the current Cap Rate.

2. The seller could use NOI of $100,000 and advertise a 10% Cap Rate.

3. The sellers could use the pro forma NOI of $140,000 and advertise a Cap Rate of 14%. Although this takes NOI into consideration, it is not actual NOI but potential NOI.

As an investor, you must know which Cap Rate the seller is quoting.

The returns of a CRE property come from: appreciation, cash flow, depreciation (tax write-offs), and principal reduction and the use of leverage.

Despite all of this analysis of cash flow, often, the biggest chunk of your investment return comes from appreciation. This is in addition to positive cash flows! That’s what makes commercial real estate so attractive.

Often properties with the greatest potential for strong appreciation are newer or in good locations and are offered at lower Cap Rates. In other words, they are priced higher. On the other hand, properties that are in poor condition, or have ground leases, are much harder to sell. As a result, a seller may try to attract buyers by advertising a higher Cap Rate. Buyer beware!

The calculation of Cap Rate only considers the first year of NOI. It considers the upcoming year and either bases it on actual or pro-forma NOI. But what if you own the property for longer than 1 year?

The Cap Rate should not be the only factor considered to determine whether to buy and how much to pay for a property but it is a good way to quickly weed out investments not meeting the investor’s criteria or to quickly qualify investments that warrant further analysis.