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How Cap Rates Influence Your Commercial Appraisal
Definition of Cap Rate:
Have you ever heard someone state that a property traded at an 8 cap? It sounds important, but it is not that easy to understand, especially for the lay person. Is a high cap rate a good thing or a bad thing? I will tell you this, it is best not to learn this concept from some guy with slick hair, wearing an ill fitting navy blue blazer with gold buttons, cruising for property in the light industrial section of town.
“Cap rate” can seem complicated at first, but makes more sense with examples. The concept of the cap rate is basically a way to calculate a rate of return on an income generating property, based on recent performance or expected performance. I see cap rates as a good way to compare the risk and reward of a real estate investment against other real estate investments, as well as other income-based investments which don’t have the influence of leverage. One more thing... “cap” is short for “capitalization”.
What if I only invest in Residential Real Estate?
If you are primarily a residential investor, I would encourage you to read on because commercial valuation principals can also be applicable to buy and hold SFR and small multi-family investments because of the emphasis on income and investment return. Too often residential investors can become infatuated with buying a property based on a low price or price per square foot when the income aspect of the investment may not be all that great.
Importance in the Appraisal Process:
Most commercial appraisals are based on the income approach, which is usually found in the last few pages of the document. From this perspective, cap rates are arguably the most important variable in determining the value. Everything else in the appraisal is more or less used to substantiate the income-based value. This can be hard to swallow when you just dropped $10,000 for a phone-book-sized report that is full of data, a lot of which is not all that relevant. The income approach involves deriving a value based on the property's income and a cap rate. The cap rate used is derived from other income property transactions in the property’s area. Although commercial appraisals consider three valuation approaches, the income approach generally takes precedence. This certainly makes sense: the bank is most concerned with the income of the property as it will be the primary source of the loan repayment.
The other two commercial appraisal approaches include the cost approach and market approach. The cost approach is more applicable to new or newer constructions while the market approach is mainly driven by price per square foot figures. It is similar to residential property appraisal. So again, the appraisal value that is based on an income approach, comes down to the market cap rate used. If similar properties in your market recently sold for an 8 cap then that is likely what the appraiser is going to use.
A cap rate is obtained by dividing the property’s net income by the purchase price.
Simple math example #1:
Property Net Annual Income: $100,000
Property Purchase Price: $1,000,000
$100,000 / $1,000,000 = 10% cap rate.
Simple math example #2:
Local market cap rate for high quality apartment buildings = 6.5%
Verified and Adjusted Net Annual Income for prospective deal = $100,000
$100,000 / 0.065 = $1.54 million (potential) value
Don't confuse cap rates with the cash on cash return:
In the cap rate calculation, annual net income excludes principal and interest or any other financing related costs. Although one property may be easier to finance compared to another, the terms of the financing will be heavily dependent on the borrower's credit and individual financial strength. Because of this, including borrowing costs in the calculation would cloud the comparability of differing properties. Always be sure to calculate the cash on cash return on a real estate investment, in addition to considering the cap rate, as the benefit of leverage will result in a different view of an investment opportunity.
What Factors Influence Cap Rates:
1.Market Condition - At the end of the day, cap rates are a very local indicator. This makes sense as real estate activity will have a strong correlation with the local economy and reflects the liquidity of the property. If you are in an active market with rising rents and rising values, cap rates will trend down as buyers will view the opportunity positively and therefore as relatively safe. In a declining market, things will appear more risky, less liquid, and investors will demand a higher return (higher cap rate).
2.Property Types - Often described as collateral types, commercial real estate is categorized as either office, retail, warehouse, industrial, apartments, hotel, raw land, farm land, or mixed use. Additionally, there are variations in these categories to include more specialized facilities including medical office, cold storage warehouse, senior living apartments, etc. My point is that you could have a hotel with $500,000 in net income and a warehouse in the same market with the same net income but the cap rates might be very different.
3.Property Class - Properties are generally classified as A, B, C, or D. Age is generally a big part of property classifications as properties inevitably slowly degrade. However, the Empire State Building is an example of an older office building that is still considered class A, as it has been well maintained and is in a prime location. Lower grade properties are often defined by the degree of deferred maintenance and obsolescence. Generally speaking, higher quality properties will sell at lower cap rates to reflect the lower risk.
4.Tenant and Lease Quality - Imagine a strip mall at a busy intersection in your city. If that strip mall features a Starbucks, Chipotle, and an Apple Store, it will most likely sell for a lower cap rate (lower risk) than the very same property that instead features a mom and pop dry cleaner, a pawn shop (We buy gold!), and a Radio Shack (Where have you gone Tandy!). Additionally, the lease terms must be considered. Long leases provide stability. Escalating rents also provide inflation protection.
5.Property Age and Condition - Let's say you were shopping for an apartment complex and you found two that had nearly the same net income. One complex was five years old and featured a modern mechanical system, a modern roofing system and high quality concrete stucco. The other was built in the late 1970s and has some obvious deferred maintenance. In this situation, the older property should sell for a higher cap rate to adjust for the maintenance risks that the investor will assume.
6.Credit / Interest Rate Environment - If financing is easy to obtain, cap rates will trend lower. Interest rates are reflective of the global and the national economy and also impact the liquidity of the property. Interest rates are important for two reasons. The first is borrowing costs. When rates are low, prices will trend upward as buyers will justify spending more on a property due to attractive financing. Secondly, interest rates impact the bond market (as well as the stock market), which is a competitive investment option to real estate. If an investor can only realize a return of 2.5% from investing in a 10-year treasury bond, then investing in a real estate opportunity, albeit more risky, at say 8% may be considered a tolerable trade-off. However, if interest rates increase to 3.5%, then the riskier real estate investment at 8% will no longer look as attractive and will have to be adjusted to a higher level of return.
7.Tax Laws - Changing laws can impact the tax treatment of certain types of real estate and other investments. Such changes can come in the form of property tax changes, depreciation, or income tax changes. A change at the state or federal level can instantly change property values.
Valuing Real Estate is an Art:
You must ask yourself: will the color scheme of your ascot and beret go well with your HP 12c calculator? Why? Because valuing commercial real estate is not purely quantitative, it is also a bit of an art-form. The appraiser will have to make a lot of qualitative adjustments to comparable sales when determining the market cap rate.
As investors, we know that each and every transaction is always a bit different. Even if you are buying condos in the same building, no two units are exactly alike. One might be on a higher floor. One might get a bit more sunshine. One might be further away from an elevator. There may or may not be a view. Commercial real estate differences are just on a larger scale. What about location? Is there additional land? Has the property been poorly managed and maintained? Why are the (tax, utility, maintenance, etc.) bills so high? With commercial real estate, this is accentuated based on the focus on income and the influence of cap rates. The value of a property could go up by either improving the income of the property or by market conditions improving (lower market cap rates).
Odd Ball Comparable Transactions:
It is very important to identify and understand the outlier transactions in your market. Say for example you see an apartment building trade at a 3% cap rate. It might be a super low risk investment, but more likely there is more to the story. A deeper dive might reveal that the new owners are planning to give it a slight make over and then condo it out with the investment return coming from the profit on selling the individual units. On the other extreme, perhaps you see a property that just sold for a 20% cap rate, but looks like a relatively safe investment on the surface. If this was an office building transaction, it might be because the new owners knew that a major tenant was not going to be renewing a lease or that the building has a significant deferred maintenance issue like roof problems or mechanical system challenges. A lower price (higher cap rate) would be justified to accommodate the risk associated with dealing with those problems.
With a Grain of Salt:
Even in today's hyper information age, it is very difficult to obtain accurate information on a commercial real estate transaction unless you were intimately involved. From my commercial appraisal days, I recall countless hours calling property owners or real estate brokers trying to obtain enough information to validate a comparable sale's financial info so that I could back into a cap rate. Often the transaction had been concluded a few months previously, which meant the person on the other end of the phone had to rely on memory or an old spreadsheet. Getting info on a historical transaction from a commercial broker can be pretty difficult, especially in a small market. Once the deal has closed, it is out of sight, out of mind, and the broker wants to move on to the next deal. Why is this a problem? Because the net income number on comparable properties may or may not include certain items. For example, the owner of a 100 room Hampton Inn may have acted as the general manager of the hotel. Did he take a General Manager's salary? Is the salary realistic? Same for an apartment building. Is there a property management fee included? Such cost inclusions or exclusions can really make a difference in the net income. Uncertainty within a net income number becomes amplified when a cap rate is applied so that you can come up with a value. Let's look at an example to see the impact:
Let's say a building sells for $3 million and we have a rather cloudy net income number of $250,000. We are unclear if they were light on their maintenance expenses and management costs. $250,000 / $3,000,000 = an 8.3% Cap Rate.
Instead, what if we determined that they performed their own management valued at $20,000 per year. Now we are looking at $230,000 / $3,000,000 = a 7.7% Cap Rate. That is a 0.6% difference.
Apply that difference to your own deal and you could have a fairly large range in value. Let's say you have a potential deal and you feel good that net income is $300,000. If you apply a 7.7% cap rate (300,000/0.077), you have a value of nearly $3.9MM. With a 8.3% cap rate (300,000/0.083), you have a value just over $3.6MM. That 0.6% difference in cap rate translates into a 7% overall reduction in value! That huge swing could impact your borrowing capacity and your overall view of the deal.
If the bank breaks the bad news that your appraised value came in low, it will make you wonder if your appraiser had good comparable data. The appraiser will attempt to negate this risk by gathering data on several comparable sales and making adjustments for differences. The appraiser will also consider published cap rates offered by various survey firms. Such activities help, but at the end of the day there is still a lot of room for artistic liberties and misunderstanding.
Be Pro Active!
So what can you do as the real estate investor? Here are some tips:
1.First off, know your market. If something sells, go talk to the previous owner or the broker and try to get some information while it is fresh. That info will be invaluable to you when evaluating your next deal or in providing support for your appraisal. Getting to know the local players might also help you get a lead on an off market opportunity.
2.Once you have the deal and you are in the funding process, assisting the appraiser is a good use of time. Like a lot of professions, appraisers bid for each and every job. Once committed, they are stuck with a set amount they will receive for the work. The easier you make their job, the less time it takes them to do the work. That makes the job more profitable and improves the chances that they will have a warm, fuzzy feeling about you. Share with them your comparable sales information. Even just pointing the appraiser in the right direction in terms of the best local sources for transaction info can be really helpful. Also going over your investment strategy with the appraiser will help them to understand your value and the role you play in your market.
3.If an appraiser calls you to verify a comparable sale that you were involved with, please spend the time to give them quality information. You may be pleasantly surprised with the information you receive in return!
Comments (3)
Great article, many thanks Mark.
Tim Flora, almost 5 years ago
Thanks very much for this article! I understand some past experiences a bit better...the commercial/residential line dividing a bank's loan officers makes for some confusion when talking about appraisal goals.
Sarah Borduin, over 7 years ago
Great article Mark! I am only a residential guy, but you have some great tips on some other ways to evaluate my buy and holds.
Jonathan Godes, almost 9 years ago