Cap Rates ?

Well, you've got your French Foreign Legionnaire cap, your nurse's cap, your painter's cap, baseball caps and lots of other caps but that's not what this particular post is all about.

This is about capitalization rates - aka the CAP RATE - which is a metric commercial real estate owners use to determine the value of their property. Here is one definition randomly taken off the Internet:

"Capitalization rate defines the percentage number used to determine the current value of a property based on estimated future operating income. In other words, taking the net operating income from a commercial property and dividing it by the capitalization rate would yield the approximate current value of the property".

That was fun reading! For the sophisticated commercial property owner the above will make sense. For many prospective tenants it means naught. And so with that in mind I will try and give it some context.

Recently I have been negotiating a lease agreement on behalf of a Landlord client whose property has been vacant for quite a while. Naturally the prospective Tenant feels that their low ball offer should be gratefully received and accepted by my client. In their mind, "isn't $10,000 a month better than no rent at all?"

The answer is "maybe, maybe not". It depends upon lots of things a few of which considerations include:

a) how much debt the Landlord has on the property and if they need immediate cash flow to make mortgage payments

b) what the Landlord's strategy is for holding the property - long term or short term.

c) how long a lease term is being contemplated and what type of rent escalations are in the proposed lease.

d) how this property asset value affects Landlord's ability to borrow money off it, make capital improvements, leverage it to buy other properties or even to purchase hundreds of thousands of caps to launch a new business venture!

OK. So let me try to illustrate how rent affects property value. Let's say it a building has potential rental income of $1,000,000/year. And let's say that it costs $150,000/year to run the building. Though it's more complex and detailed than this, for the sake of this blog let's assume that means this building generates $850,000 in Net Operating Income (NOI). And now let's apply a CAP RATE to determine value. The cap rate is not a fixed number - it's a range based upon market analysis. One could argue that it should be 8% - or 6% - but let's assume for the purpose of this exercise that the cap rate is set 7.5%.

$850,000/.075 = $11,333.333 would be the value of the property if it could generate this NOI with a 7.5% cap rate.

Now getting back to the case in point where there is a prospective retail tenant offering rent much less than my client believes their property to be worth. Let's say this prospective tenant's offer would reduce the NOI to $750,000/yr and that the operating costs and the cap rate (7.5%) remains the same.

$700,000/.075 = $9,333,333 would be the value of the property. So by accepting this offer the Landlord has in essence accepted that their property is worth $9.3 million instead of $11.3 million!

In conclusion, the above has been intended only to provide a conceptual framework as to what CAP RATES are all about - it's more detailed of course. I often try to end my blog with a song that has some relationship to the topic of the blog - and this one proves a tough challenge. Cap rates? Caps? Well this is the best I could do.. lots of caps in this one