Valuation in Commercial Real Estate is driven by income, and a key component to understanding the relationship between income and value is the CAP rate. This article is designed to give a basic understanding of the basic fundamentals of the CAP rate, how it is calculated, how it is set, what affects it, and how it effects the valuation of real estate.
The most straight forward way to understand the CAP rate is that the CAP rate is a measurement of risk. The CAP rate is the rate of a return an investor would make if they purchased a piece of commercial real estate with cash (no loans). Someone buys a CRE property for $1,000,000, that property generates $60,000 of income after expenses, that property has a CAP rate of 6.00%.
The higher the CAP rate, the riskier the investment and the higher the rate of return and investor would expect to receive on that investment. The CAP rate has an inverse relationship to value, the lower the CAP rate the higher the value (assuming income is consistent). This make sense, if an investment is less risky, then it will have a higher intrinsic value than a risker property.
Many things effect CAP rates, but there are three major factors that we will speak about.
Asset/Property Type
First, and perhaps the easiest to understand and calculate is the asset/property type. By asset type we mean Apartment Complex, Office Building, Retail Space, Grocery Store, Church, and all the other building types. The easier it is to A) manage the asset and B) sell the sell, the lower the risk and the lower the CAP rate.
For example, an apartment building will have a lower intrinsic CAP rate than a hotel because owning a Hotel takes a specific skill set to successfully own/manage. It is more challenging to find good financing for a hotel, and as apartments are substantially more common in the marketplace, there is a much small market of buyers that can the property can be sold to. For all these reasons a Hotel will have a substantially higher CAP rate than an apartment building.
Property condition, age, and design features are also included in this.
Location of Property
Where an asset is located has a major impact on the CAP rate. When reviewing the location we review both the physical location of the subject property AND the suitability of the subject property in a given marketplace.
The physical location of an asset as it relates to the CAP rate is the easiest to understand. Assets located in major metropolitan areas typically have lower risk than those assets located in secondary or tertiary markets. The risk is lower in larger areas because there are A) more potential buyers if the property needs to be sold B) more property management companies if the property needs to be third party management and C) more lending institutions that will provide financing in their market area.
The suitability of the asset in its location is also fairly straightforward. Is the market are oversaturated or under saturated for a specific asset class. Is there a geographic need for a specific asset class (hotels in Hawaii, solar plants in the desert, student housing next to major universities, etc)? If so then this lowers the risk of owning that type of asset class in that geographic area, and lowers the CAP rate.
Market Forces
The third major factor in influencing CAP rates are Market Forces. Market Forces are typically intangible forces that do not relate specifically to the subject property or more broadly to asset classes in general. Examples include but are not limited to:
• How much capital is available in the marketplace to invest in real estate.
• The local and general economy
• Inflation & Deflation
• Lending rates, both short term and long term
• General investor appetite for commercial real estate (CRE vs. Bonds vs. Stocks).
It is not in the scope of this article to go over the how these market forces drive CAP rates.
The Big Question
So, the big question is “Who then sets the CAP rates?”. The horribly vague answer is nobody and everybody. The CAP rate is set by the market, by the masses of people purchasing, selling, leasing, and refinancing commercial real estate. When a property is sold the sales price, the CAP rate and the NOI is readily available as public records. CRE professionals can track that information and make general comparisons that will allow for valuations of other CRE when valuation is required.
There are professionals in CRE whose sole job it is to analyze CAP rates, but there is no person who “sets” CAP rates. Determining CAP rates, unfortunately, is about 80% science and 20% art, and it takes someone substantially experienced in CRE, with a very specific understanding of the subject asset to make the educated estimation of CAP rates.