CRE 101: Cap Rates Are Most Useful When Applied to Stabilized Assets (Part 3)

Commercial Real Estate

Are capitalization rates meaningless when applied to value-add transactions? The answer is…it depends. Capitalization rates, or “cap rates”, are a common market metric used to provide an unlevered return for an asset in a market, determined by dividing the net operating income by the property’s purchase price, or value. Cap rates can be meaningless when determining the value of a property for acquisition if the property isn’t stabilized, i.e., the asset is ripe for a value-add business plan. If you look at a number of sales of like assets in the market in the past six to twelve months, the market will have a general range of cap rates that essentially set the average cap rate for the market. Once a market has an average cap rate, buyers and sellers can use the cap rate for pricing guidance by dividing the NOI by the cap rate to get to the “value” (rearranging the prior calculation used to determine the cap rate).

If an asset isn’t stabilized - either the rents are lower, the vacancy is higher, the lease terms are shorter, or expenses are greater than the comparable assets in the market - then the NOI is not maximized. In such instances applying the market cap rate will not achieve accurate pricing because there is room for improvement and execution of a value-add business plan. A value-add business plan generally requires adding capital improvements at a cost, increasing rents and decreasing expenses.

An easy way to illustrate how this plays out is with a four-unit Class C office building. The leases in place are for $1 per square foot and the building is 10,000 square feet, so the owner receives $2,500 from each tenant, or $10,000 a month, or $120,000 per year in gross income. Expenses are 40% of the income, or $48,000, so the property nets $72,000. At a 7% cap rate the property is worth $1,028,571, or $72,000 divided by 7%. If the owner chose to put this property on the market, they could reasonably ask for a valuation of a 7% cap rate, which means the building has a $102.85 per foot sales price. But if two of the tenants move out, the property is now 50% occupied and the property grosses $50,000. While some expenses go down, fixed expenses like property taxes and insurance remain the same, and so if expenses are now $38,000, the property is netting just $12,000 in income. If you were to use the same 7% cap rate analysis to value this asset, your value would be $171,428, or $12,000 divided by 7%, and the price per square foot is $17.14. That’s an 83% reduction in value after losing 2 out of 4 of the tenants. In truth, tenant turnover might actually be a good thing; if the market is now $1.20 per square foot for leases, and the owner can lease to two new tenants, the property is now grossing $1 per square foot for 2 tenants at $5,000 per month and $1.20 per square foot for 2 tenants at $6,000 per month, for a total of $132,000 per year. With 40% expenses of $52,800, the property nets $79,200, or $7,200 more per year than it did with the prior tenants. Using the same 7% cap rate the property is now worth $1,131,428, or $79,200 divided by 7%, or 10% more than it was with the prior tenants. The purpose of this illustration is to show that applying a cap rate to an unstabilized building is not an appropriate way to value an asset and should not be used in these circumstances.

For a value-add buyer, however, the market cap rate could be used to determine an estimate of the future value of the unstablized asset once a value-add business plan has been completed. In the above example, increasing rents from $1 per square foot to $1.20 per square foot resulted in an increase in value of $102,857 ($1,131,428-$1,028,571). Consider if the current tenants at $1 per square foot required $5,000 to move out, and the new tenants required $5,000 in tenant improvements to move in at $1.20 per square foot. If the owner had to spend $20,000 ($5,000 per each tenant moving out and $5,000 per each tenant moving in) to “add value”, in order to raise rents by $.20 and increase the value of the asset by $102,857, the $20,000 investment would net a profit of $82,857. The value-add buyer would use the market cap rate to determine a potential stabilized value based upon the expense of replacing the tenants and realizing an increase in rent.

Because cap rates provide the most value when used to set a baseline return on similar types of assets in a particular market, it is easy to see that the optimal way to use them is to apply them to either a stabilized asset, or to assess the potential future value of an asset using a projected stabilized NOI.

The final article in this series will address the question, “what should my cap rate be?”, and will explore what factors impact the answer to that question.

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