What is a “Cap Rate” and What Does It Mean to Me? Investor 101 Series
Facts and Fiction about “CAP” rates.
Since initially writing this blog, there has been many new articles by many authors about the definition of “Cap Rates” and what they mean. Most of the articles are pure definitions that most people have difficulty understanding how it may affect them. Other articles are specific to particular types of real estate. What you’ll find is that “Cap Rates” are not utilized differently by type but the rates are adjusted by the type of real estate that you are looking at. The basic math and how it is used does not differ. If you read on you’ll get a basic understanding of how they are determined and why it is important to know.
After spending many years in the commercial banking industry and making the jump to real estate, it was very interesting to me that many people do not know what a “Cap rate” is. First and foremost, it is NOT an indication of or a fixed rate of return. “Cap Rate” is short for capitalization rate or a mathematical rate that is assigned to a property based on the risk of the investment. The higher the risk, the higher the rate. For instance, let’s say you’d put money into a 30-year investment that is yielding 5.6% annually and is federally insured so there is no risk. That would be the base rate so anything higher in risk, would be a higher rate because why would you take more risk with your money and not get more in return..the answer is you wouldn’t! Now let’s say a property has one tenant that pays income to the property owner and has been in the property for many years, has always paid on time and has no wish to move. The income received from the rent is sufficient to make the mortgage loan and return’s a substantial amount to the owner. This is more than likely to have a low cap rate as there is very little risk probably somewhere in the 6.5% rate, as there is always some risk.
Now, if you have a commercial building where there are multiple tenants and you average 10% vacancy and barely can make the mortgage payment, this is a higher risk than the other example and would have a much higher cap rate, let’s say 8%. What the cap rate tries to do is adjust the value of the property to what the income can afford. Using the previously mentioned cap rates and a annual net operating income of $100,000 for round figures, the value of the commercial building would be $1,538,462 using a 6.5% cap rate and $1,250,000 using a 8% cap rate. That means the higher risk and thus higher cap rate would cause the property to be worth $288,462 or 18.75% less, in this example.
Cap rates are one of the basic tools used by appraisers and smart bankers in evaluating the potential value of commercial buildings. Lenders typically would like higher cap rates as it lessens the value, makes loaning money on the building a better risk and is a more conservative approach. Conversely, if you are a savvy commercial property owner, you’d use a low cap rate to increase the value of the building you have for sale. And yes, over the years, this has been done frequently. Normally it doesn’t work because the lenders and appraisers come to their independent judgement on what the cap rate should be and adjust it to a realistic value. What then happens is the seller either comes down in price or you have to put down the difference between what the seller wants and the lenders would approve. In other words, you lose out!
Remember, investing in commercial property is risky even if you know the potential tenant(s). You need to evaluate the income and expenses over a multiple years and also look at the tenant leases. Until then, if you want to know whether or not your real estate adviser really knows about commercial properties you might start by finding out if they understand cap rates, I guarantee you the lenders will and who do you think controls the money? Good hunting.
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If you have questions about utilizing this type of valuation, please let me know.
Dave Sato
Real Estate Professional
dave@seattlepowersearch
425-213-6411
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