I need help with CAP rates

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I need help with CAP rates

Postby Petrocelli » Fri May 03, 2013 10:00 am

I own an interest in a piece of real property with other people. The property has a factory on one part of it, and 16 small commercial units on another part. It has no liens against it and generates approximately $250,000 a year in income.

One of the other owners is interested in buying my interest. I am obviously going to retain an appraiser, but before I do, I would like to get some idea of its value based solely on the income presently generated.

I am totally unfamiliar with CAP rates, but know they can be applied to value a property. Based on the income, can anyone who is familiar with CAP rates give me an idea of what the property is worth? Or is more information necessary?

Thanks in advance for your help.
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Re: I need help with CAP rates

Postby kmok » Fri May 03, 2013 3:08 pm

Cap rate is the ratio of the operating income divided by the cost. So therr are two variables, cost, net operating income, and cap rate. If you have a reasonable cap rate for your property, you can calculate the proprrty value. If you use the appraiser's value you can calculate the cap rate to see if it make sense.
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Re: I need help with CAP rates

Postby Valuethinker » Fri May 03, 2013 3:18 pm

Petrocelli wrote:I own an interest in a piece of real property with other people. The property has a factory on one part of it, and 16 small commercial units on another part. It has no liens against it and generates approximately $250,000 a year in income.

One of the other owners is interested in buying my interest. I am obviously going to retain an appraiser, but before I do, I would like to get some idea of its value based solely on the income presently generated.

I am totally unfamiliar with CAP rates, but know they can be applied to value a property. Based on the income, can anyone who is familiar with CAP rates give me an idea of what the property is worth? Or is more information necessary?

Thanks in advance for your help.


As per other post.

Rent (Net Operating Income)/ Value = cap rate

So what a surveyor (appraiser) does is look at similar properties that have sold, comparing what they sold for against the rental income they generated.

Say that's 8%. Then they take your rent and divide by 0.08 to get an estimate of value.

No 2 properties are identical. In the UK, right now, a small commercial/ industrial property like you describe might get 8-9% yield (same idea as a cap rate). I would imagine in the US somewhat lower (your economy is more advanced in recovery). A really prime office building might get sub 5% (ie 20-25x rent).
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Re: I need help with CAP rates

Postby Globalviewer58 » Fri May 03, 2013 3:19 pm

This page has some detail from 2012 regarding CAP rates for various types of properties.

http://www.ftense.com/2012/03/commercia ... k-cap.html
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Re: I need help with CAP rates

Postby Frugal Al » Fri May 03, 2013 4:11 pm

drewswan wrote:This page has some detail from 2012 regarding CAP rates for various types of properties.
http://www.ftense.com/2012/03/commercia ... k-cap.html

Interesting data offering a good starting point. Even so, average CAP rates can be dangerous--different locales can offer quite variable cap rates. Also, the strength of the lease portfolio (term, escalator clauses, triple net, credit ratings, etc.) can play an integral role.
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Re: I need help with CAP rates

Postby Grt2bOutdoors » Fri May 03, 2013 4:44 pm

Frugal Al wrote:
drewswan wrote:This page has some detail from 2012 regarding CAP rates for various types of properties.
http://www.ftense.com/2012/03/commercia ... k-cap.html

Interesting data offering a good starting point. Even so, average CAP rates can be dangerous--different locales can offer quite variable cap rates. Also, the strength of the lease portfolio (term, escalator clauses, triple net, credit ratings, etc.) can play an integral role.


Exactly - I'd be very interested in knowing what the terms of each of the leases are - if you have rent escalations clauses in the lease projecting forward that needs to be taken into account (an NPV of rental income) and given low rates out there that should increase the value of the property even more so. Is the property fully depreciated? I would think if you have a fully depreciated interest - you cashing out may lead to unforseen tax consequence for you if your basis is low. Is this property in a location that was hit hard in the real estate downturn - is it on it's way back, back or above and beyond? I always question why someone wants something - there must be a motivating factor, you want it bad enough - then make a very good offer.
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Re: I need help with CAP rates

Postby SeattleCPA » Sat May 04, 2013 10:04 am

Here's a little bit more info about cap rates, too...

To get the project rate of return, you need to add the property appreciation rate to the cap rate. E.g., if the cap rate is 5% and the appreciation rate is 3%, your project rate of return is 8%. This is equivalent then to adding the dividend component of a return and the growth in share price component of a return together to get your return on investment in a mutual fund or stock, etc..

Also, if you use leverage (borrowed money) you can compare the overall project rate of return to your borrowing rate to see if you're getting positive financial leverage and thereby amplifying your returns. E.g., if your overall project rate of return is 8% and you borrow money at 4%, you're getting massive positive financial leverage.

One can also use this little relationships to see what went wrong with real estate during the recent meltdown. People bought properties assuming 3% cap rates and say 5% appreciation rates so overall 8% project rate of return--perhaps all funded with money costing 6% or whatever. So good financial leverage there though tellingly very dependent on the appreciation rate to make everything work out in the end...And then it turns out that the appreciation rate was really minus 10% or whatever... and this meant in reality you're borrowing money at 6% to invest in somethingn that's "earning" minus 7%. Brutal. Yikes.

It's an older web site that talked in terms of how the cap rate and project rate of return math works for shortsale properties, but there are longer discussions about these calculations at http://www.howdoibuyashortsale.com/over ... return.htm as well as some free spreadsheets you can use.

Just for the record, I think the shortsale opportunity seems to be "gone" now... (I did three short sale properties and got great deals, but I think the discounts at least where I was shopping have now gone away.)
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Re: I need help with CAP rates

Postby Don46 » Sat May 04, 2013 10:41 am

I'm no expert on commercial real estate (CRE) but I've bought and sold three properties, all connected by 1031 rollovers.
The cap rate is everything in CRE sales. I'm currently selling my property and the bids actually came in expressed in cap rate first, then dollar amount. I got a much better price than I expected because at this point the CRE market is strong for sellers in the US. People are looking for tax shelters and CRE can work to convert income to capital gains through depreciation.

I bought at about 8% Cap and am selling at about 7.6% cap. We put it on the market at 7.5% cap. The offers usually come in pretty close to the list price I am told. Mine is a medical office building with a ten year lease and two 5 year renewal options with a very strong international firm as tenant. There are so many variables, I think it is impossible to determine a cap rate without a close appraisal by someone who really knows the CRE market and not just in your local market. It will be worth your time and money to pay an appraiser who is working for you and not the buyer. I sold through Colliers International working with a local agent in SC and a team in California. We got about 6 bids and then were able to come back with counter offers to the financially strongest bidders. I found it very difficult to learn on my own about current trends in cap rates and sales. I'm glad I had a good team of professionals.
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Re: I need help with CAP rates

Postby smackboy1 » Sun May 05, 2013 4:32 pm

Petrocelli wrote:I am obviously going to retain an appraiser, but before I do, I would like to get some idea of its value based solely on the income presently generated.

I am totally unfamiliar with CAP rates, but know they can be applied to value a property.


I'm not an appraiser but I have owned and managed commercial RE. I don't have any answers but depending how deep into the rabbit hole you want to go I can give you some places to start looking. As others have mentioned, you're going to need your own appraisal. Keep in mind that an appraisal is a useful tool, but it's just a bunch of guesstimates based on assumptions. As such the "truth" of the appraisal can be manipulated to serve your (or anybody else's needs).

V=I/R (Value = Net Operating Income / Capitalizaton Rate)

I'm not going to go into NOI, but for your property is an estimated stabilized 1 year NOI a reasonable assumption?

There's no single definition of "cap rate" and many ways to come up with one.

http://mcgladrey.com/Real-Estate-Adviso ... ation-Rate

The problems with coming up with a cap rate is the quality of the assumptions going into it e.g. when calculating a market cap rate, how reliable are the publicly available figures, or how similar are the properties?

Instead of using market derived cap rate, a derived cap rate is another option. Here is an explanation of the band of investment method:

http://www.creonline.com/cap-rate-formula.html

But it's not like derived cap rates are without issue. Here is an explanation of why mortgage equity method is better:

http://www.dcfsoftware.com/mtgequity.htm

And for the other side of the argument, here is an explanation why the mortgage equity method is worse:

http://incomepropertyanalytics.com/shou ... e-returns/

As you can see there are lots of assumptions going into the calculations, some more dubious than others. And a very small change in the cap rate can have a large effect on the value. Hope this helps.
Disclaimer: nothing written here should be taken as legal advice, but I did stay at a Holiday Inn Express last night.
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Re: I need help with CAP rates

Postby WhyNotUs » Sun May 05, 2013 5:41 pm

Someone said that you need an appraiser to determine Cap Rate, not true but you do need accurate operating expense info, which you have access to. I am assuming that your $250k income is NOI for the entire site? If so, then if you received an offer based on Don46's example of 7.6 cap rate, we would assume the total property is worth $1.9M. You would multiply that by your share (%) in order to assess your stake using that cap rate assumption. Make sense?

Without knowing a lot more about your situation, Don's number is in a reasonable range for back of the envelop "does it work" calculations.

As has been mentioned, cap rates are a good ruler for looking at the reasonableness of a deal but only one of many inputs in establishing value. From the limited info that you provided, it looks like there are some positives in the additional info for your property. I would not get too locked into CAP rate or let the appraiser do so as that may not make your best case for valuation.

Someone else mentioned appreciation and talked about a rate. Selling that blue sky does not happen in too many situations. It did happen leading up to 2008 and we know how that turned out. You can sell the appreciation to date, you can get a taste of the action if a shiny new project is opening up across from your Dairy Queen in the next two months, or the City just built a new highway with water and sewer service but any expected appreciation goes to the purchaser (no risk, no reward). One way to get an additional taste is to finance the purchase at commercial interest rates.

The other thing to consider is whether you have a use for the money upon sale that can return as well after taxes (sale year and whatever you plan to put the money into instead) as the property and what your tax impacts will be. Not sure where your investment is in depreciation cycle but I would want to talk with my tax advisor before agreeing to a sale.There is a reason that 1031 transactions are so popular. I have a friend who chose to sell an inherited "cash cow" thinking that it was the top of the market, then they had to deal with tax issues and reinvestment- oops.

Good luck, it is nice to receive an unsolicited offer. A nice problem to have whether you take it or not.
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Re: I need help with CAP rates

Postby Petrocelli » Fri May 17, 2013 11:16 pm

Thanks for the replies. After reading them, I realized I know nothing about this area, and it would take too long to learn. I decided to hire an appraiser.
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Re: I need help with CAP rates

Postby playtothebeat » Sat May 18, 2013 1:34 am

I work in commercial real estate, so here are my 2 cents..

First thing is, any time you buy or sell commercial real estate, do yourself a favor and hire a good real estate attorney and an accountant. Taxes are a HUGE HUGE part of real estate transactions. What is your basis in your asset? How much tax will you have to pay from this sale? Do you plan to roll those funds into a new property (1031 exchange)? These are important questions to answer.

Secondly, to answer your question, a cap rate is in very simple terms a rate of return (in perpetuity). Think back to your corporate finance class - you were taught to value a perpetuity by taking the coupon payment and dividing it by the interest rate. This is exactly the same thing. Value = NOI (coupon) divided by cap rate (rate of return). In other words, if you're buying a property at a 7% cap, it means you're getting a 7% return on your investment assuming the NOI at that time (obviously one of the main points of buying real estate is for value-add purposes - i.e. you may get a new tenant in there who will pay higher rent and thus generate additional value).

Another thing to consider with cap rates is they're not necessarily static - I.e. if you have a property with tenants who all pay "above market" rent, the cap rate for that property is different than that same property assuming all tenants are at market (above market rental rates = higher risk that tenants will default or will stop paying that rent; as such, higher risk = higher rate of return = higher cap rate). Likewise, a credit tenant will drive the cap rate lower. Think of it as if you're an investor - you'd probably accept a 6% return knowing that all of the income is derived by Nordstrom and Target, where as you may need a higher return if it the income comes from mom-and-pop shops since the risk is of loss of income is greater; a higher cap rate = lower value (assuming NOI stays the same).

By the way, cap rates are getting compressed quite a bit over the past year or two given where the interest rates are. That's one of the big fears in commercial real estate today - what happens once interest rates go up? after all, if you can get a 4% return in treasuries, you'll probably want significantly more than 5 or 6% in real estate given all the risks involved.
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