Posted by Donald Teel, Arizona Commercial
Commercial investors and real estate brokers/agents toss around the term “cap rate” as if it were some sort of tell-all with respect to commercial property value or the measurement of the strength of a commercial property investment.
Hold your horses!
Can a CAP rate determine a property value? Are CAPS an accurate measure of an investment? Can CAP rates be trusted as a true litmus test for investment?
Answer: No, no and no. In fact, CAP rate determinations are now coming under assault.
Brokers often convey value and pricing by dividing net operating income by a purchase amount, such as 125,000 (noi) divided by $1,125,000 (price) equals a cap rate of 11.1%.
CAP rates are simply the measurement of a property value for a given 12-month period “IF” the property were purchased “cash.” CAP rates are impacted when investors utilize financing and the terms of financing, such as interest rate, points, call date, etc., impact “true cap rate.”
Real World CAP Problems. What happens in a market where the actual or contemplated lease rates fall below levels suitable for so-called “adequate” cap rate?
Savvy investors know how important cash flow is and more importantly, how important predictable and sustainable cash flow is in a down market. Real world cap rate problems occur when the strength of rent rates is compromised by a struggling economy or by tenants who vacate properties due to their business failing to perform.
Example: If the prevailing and sustainable (emphasis on “sustainable”) market rents are anticipated to trend downward for more than 12 consequtive months due to a faltering national economy, cap rates may be a less than optimal way to determine purchase price value.
Welcome to today’s real world problem with cap rate valuation! I have a theory that the accelleration of tenant default has now become the single most powerful force in declining commercial property values. There goes sustainable NOI.
The Assault on CAP Rates. Shopping cap rates is usually a faulty initial premise in today’s market since most investors are unwilling or unable to park cash into 100% of the purchase price of a leased property.
Today, long term tenant performance is becoming less stable and the market competition for “exceptional” tenants is heating up. Vacancies are driving down NOI, lenders know this and are now adjusting their cap calculations to include historical property performance perdictions.
Cap rates as a tell-all financial apparatus are under assault and weighted calculations for financing and property segment performance MUST be taken into account by investors more than it has in the past.
A trustworthy cap rate will always be adjusted by the cost of money and the cost of alternative investments measured against real estate investment returns.
The strength of lease agreements, tenant performance, type of business and the cost of money over time (typically 3-5 years) are now more significant than ever.
Want more information about cap rates and the central and northern Arizona commercial markets? Email me or, if you prefer, call me toll free at 877-777-9100.