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Cap Rates and Why They Matter

A recent discussion with an investor inspired me to talk a little bit about how commercial properties are valued. Commercial and other income-producing properties are often valued using cap rates. Investors frequently consider cap rates when evaluating and comparing different properties. A higher cap rate may suggest a higher potential return but could also indicate higher risk, while a lower cap rate may imply a more stable investment with lower returns.


The property-specific cap rate is calculated for a particular property and represents the rate of return expected from that specific investment. To determine a property’s cap rate there’s a simple math equation.


Net Operating Income (NOI) / Purchase Price = Cap Rate

NOI = Income - Expenses (not including debt)


For example, an apartment building generating $150,000 in NOI, that trades at a 6% cap rate, would be valued at $2.5 million.

Simple math. But where things get interesting is in determining what the market cap rate should be. Let’s look at a few of the main factors in determining the market cap rate.


Perceived Risk


Year Built

The age of the building, or as we say, its vintage, generally influences the cap rate. In general, newer buildings tend to have lower cap rates. Age also factors into the class of the building, typically described as A, B, or C. A-class properties are usually newer and trade at lower cap rates than older C-class properties.


Market

The area or market in which a property is located plays a part in determining its cap rate. Nicer areas may be perceived as less risky, resulting in a lower cap rate. Areas are often classified as A, B, or C. You can find a C-class building in a B area. This particular example provides a prime opportunity to implement a value-add business plan like we did at the property we own in Minneapolis, The Crown of Kingfield. The better the area, which may factor in income, schools, or nearby amenities, the lower the cap rate.


Asset Class

Multifamily, office, retail – all these trade based on a cap rate that fluctuates according to how investors perceive the risk. For example, office space is currently trading at a much higher cap rate than it did before COVID, driving down the purchase price.


Comps

When determining cap rates, a crucial step is examining recent sales of properties that are similar to the one under consideration. These similar properties, known as comparable sales or comps, serve as benchmarks for understanding how the market values assets with similar characteristics. By studying recent transactions of comparable properties, one gains insight into the prices at which those properties changed hands. This information provides a basis for understanding market trends and pricing dynamics.


Interest Rates

Interest rates constitute a significant factor in determining the cap rate. Cap rates tend to follow the interest rate trend, as illustrated in the graph below. That's why, if you believe we are experiencing higher interest rates now compared to the future, this is not the time to sit on the sidelines.


Avoid Negative Leverage


A term being thrown around right now is negative leverage, something investors want to avoid. Negative leverage refers to the delta between the interest rate and the cap rate at purchase. If a building is listed for sale at a 5.5% cap rate and the interest rate from the bank is 6.5% there are 100 basis points of negative leverage. Negative leverage poses a challenge as it indicates that the cost of borrowing (interest rate) exceeds the return on the property (cap rate). Basically, the investment is not generating sufficient income to cover the financing costs. This scenario is generally undesirable for investors unless there is a well-defined and rapid business plan in place to elevate the property's operations to a cap rate exceeding the interest rate.

It’s best to avoid negative leverage because it can erode potential returns and increase financial risk. It's essential to carefully assess the feasibility of achieving higher cap rates through strategic improvements or operational changes before engaging in a deal with negative leverage. In the absence of a clear plan or even a few unfortunate hiccups, negative leverage can impact cash flow, profitability, and the overall success of the investment.

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