Question on Cap Rates

[David Switzer]

I understand that Cap Rates are not a set number in an area/property, and they depend on many factors.  So here's my question:

How do you strike a balance between higher cash flow vs building value?  Example:

-------------------
Tenant A - Grandma Millie's Sewing Shop
Been in business 1 year, decently profitable, signs 5 year lease.
Rent = $60,000/year

Tenant B - Eye Doctor office.
Been in business 5 years, quite profitable, signs 5 year lease.
Rent = $55,000/year

Tenant C - Subway
5 year lease
Rent = $50,000/year
-------------------

If I assign the following Cap Rates, I get these building values:

Tenant A / 10% cap rate
60k/.1 = $600,000

Tenant B / 8.5% cap rate
55k/.085= $647,000

Tenant C / 7% cap rate
50k/.07 = $714,000
(or even $45k at 6% cap rate = $750k)


-------------------

I just made up all of these numbers.  What I'm basically asking is, how do I find the right balance between cash flow and increased building value?  I.E.  $15k more in cash flow per year vs $150k in increased building value

[John Clark]

Quote from @David Switzer:

I understand that Cap Rates are not a set number in an area/property, and they depend on many factors.  So here's my question:

How do you strike a balance between higher cash flow vs building value?  Example:

-------------------
Tenant A - Grandma Millie's Sewing Shop
Been in business 1 year, decently profitable, signs 5 year lease.
Rent = $60,000/year

Tenant B - Eye Doctor office.
Been in business 5 years, quite profitable, signs 5 year lease.
Rent = $55,000/year

Tenant C - Subway
5 year lease
Rent = $50,000/year
-------------------

If I assign the following Cap Rates, I get these building values:

Tenant A / 10% cap rate
60k/.1 = $600,000

Tenant B / 8.5% cap rate
55k/.085= $647,000

Tenant C / 7% cap rate
50k/.07 = $714,000
(or even $45k at 6% cap rate = $750k)


-------------------

I just made up all of these numbers.  What I'm basically asking is, how do I find the right balance between cash flow and increased building value?  I.E.  $15k more in cash flow per year vs $150k in increased building value

Why are you making up numbers? The expense of maintaining a “doctor’s building” is different from another building. Where do youthink the market is going in your locale? Remember to factor in the ancillary businesses that any particular theme of business needs, as much may not be directly tied to the base business (e.g., a cafe where patients can digest bad news - not a medical service provider or medical support provider, but ancillary nonetheless.

[David Switzer]

Oh, what I meant was a single commercial condo, not an entire building.  Somewhere between 1000-1500 SF, and the locale is excellent in a market with many people moving in and new developments coming in.

I should have said "unit" and not "building"

[John Clark]

Quote from @David Switzer:

Oh, what I meant was a single commercial condo, not an entire building.  Somewhere between 1000-1500 SF, and the locale is excellent in a market with many people moving in and new developments coming in.

I should have said "unit" and not "building"

You still ignore the theme of the building and the expenses. Methinks you are not ready

[Russell Brazil]

Cap rate is a reflection of the risk, or the perceived risk in the asset and/or the market. The higher the cap rate, the higher the risk. The lower the cap rate, the lower the risk.

This is a fundamental rule of finance regardless of what the instrument is. Whether real estate, stock dividends, bond yields. The yield of any asset is always based upon the risk.

[Chris Seveney]

@David Switzer

As others mentioned you need to factor in risk. If it’s a subway that has a corporate guarantee and option to renew that is a much lower risk than a brand new business that has a High chance of going under

What we see frequently is investors chase returns and ignore risks. This is why you see drive planning raising $300M ponzi when it offered 40% returns. You think they would have $300M if they offered 10% returns?

[Chris Mason]

You strike the balance by looking at your goals. 

If you want a risk big and win big proposition, that's Grandma Millie's Sewing Shop. 

Low risk and low return, Subway's where it's at.

For maximum sales price in 2-5 years, you need to consult a combination of your broker and a crystal ball. Silicon Valley is not rural Ohio is not east Los Angeles. One thing that will remain true for all is the outlier buyer who would want it either vacant (perhaps for their own business), or easily turned vacant. That's where your lease terms come into play. 

[Evan Polaski]

To add more color:

Your cap rate is pricing in risk.  Your risk here is

- tenant quality: who is guaranteeing each lease?  What is the need for that tenant type in the market?  Is sewing shop the only one for 30 miles?  

Lease type: are some absolute NNN? Are some capped on certain items? Are they reimbursing POA? What about special assessments from POA?

Property Condition: when was it built? How is the POA? Is it well funded? Under funded? Are there common roofs? If so, does POA cover them? If not, what happens when neighbor owner isn't maintaining their roof and water leaks are impacting your tenant?

Market Risks: you said lots of new development.  That sounds like a lot of new product entering your market that could scoop away your tenant.  Also, investor interest in this market.  

How do you strike a balance?  Well, you can be fairly confident in your cash flow, at least for a few years.  You have no real control over macro economic issues over the long term, which will have a higher level of impact on your building value.  But ultimately, because of these risks, most real estate investors see most of their return from appreciation versus cash flow.  So, you need to decide what type of personal risk you are willing to take.

[David Switzer]

Quote from @Evan Polaski:

To add more color:

Your cap rate is pricing in risk.  Your risk here is

- tenant quality: who is guaranteeing each lease?  What is the need for that tenant type in the market?  Is sewing shop the only one for 30 miles?  

Lease type: are some absolute NNN? Are some capped on certain items? Are they reimbursing POA? What about special assessments from POA?

Property Condition: when was it built? How is the POA? Is it well funded? Under funded? Are there common roofs? If so, does POA cover them? If not, what happens when neighbor owner isn't maintaining their roof and water leaks are impacting your tenant?

Market Risks: you said lots of new development.  That sounds like a lot of new product entering your market that could scoop away your tenant.  Also, investor interest in this market.  

How do you strike a balance?  Well, you can be fairly confident in your cash flow, at least for a few years.  You have no real control over macro economic issues over the long term, which will have a higher level of impact on your building value.  But ultimately, because of these risks, most real estate investors see most of their return from appreciation versus cash flow.  So, you need to decide what type of personal risk you are willing to take.

 This is excellent thank you!

[David Switzer]

Quote from @Chris Mason:

You strike the balance by looking at your goals. 

If you want a risk big and win big proposition, that's Grandma Millie's Sewing Shop. 

Low risk and low return, Subway's where it's at.

For maximum sales price in 2-5 years, you need to consult a combination of your broker and a crystal ball. Silicon Valley is not rural Ohio is not east Los Angeles. One thing that will remain true for all is the outlier buyer who would want it either vacant (perhaps for their own business), or easily turned vacant. That's where your lease terms come into play. 

 Thanks Chris!