Cap Rates and Property Valuation. Understanding the Variables.
Your Lender is considering your mortgage application. They will want to estimate the value of your property. This is an important step in their determination as to how much money they can lend to you. How is this valuation completed? Understand the variable.s
Real estate appraisers and lenders, equipped with the property’s estimated net operating income, are well positioned to estimate its value. You can too! This is done by applying a factor or rate, which converts the property’s Net Operating Income into an indication of value.
This calculation is referred to as “capitalizing” the income. The rate applied, is referred to as the capitalization or “cap” rate. This is one of the more commonly used commercial real estate valuation methods. Market data reports prepared by real estate brokerage firms often provide commentary on cap rates. This is typically presented as a range, or an average rate. They produce this information by compiling and reviewing recent sales data.
Capitalization rates reflect a combination of factors. These include yields on competing investments. An investor could elect to purchase individual stocks, mutual funds, bonds, or term deposits. The cost of financing, liquidity of the asset, and demand for the property type being analyzed are also important considerations.
Cap Rates. Understand the variables
High demand and well located properties, consistently sought after by potential investors, tend to command a lower cap rate. An example would be well located multi-family residential property. Investors have historically considered them a safe and stabilizing asset. The rationale being that everyone needs a roof over their head. An owner of an apartment building, if confronted with a particularly weak local market, perhaps as a result of a relocation of a major employer in the city, could lower rental rates on individual units should they become vacant, so as to maintain or stabilize occupancy and cash flow. Gross income in these situations is relatively predictable.
Similarly, low cap rates are typically seen with commercial properties leased on a long term basis to strong tenants. Perhaps a nationally recognized retailer, a major financial institution, or perhaps a governmental agency or department. Investor risk in such situations is low, and a sales price reflective of a low cap rate would be expected.
Conversely, a property that is perhaps not as well located, not as well leased, or which may be classified as a specialty use property, would command a higher cap rate. Examples may include a seasonal hospitality property, or perhaps a self-storage mini-warehouse property, or student housing. These types of properties typically require specialized ownership and management skills. They are perceived to involve higher owner/investor risk.
Similarly, properties situated in secondary locations tend not to have as broad appeal to investors. Buyers of these properties will generally want a premium on their return. They perceive greater risk and will not offer as high a price. It is therefore not hard to imagine that a property located in a small community will command a price, and consequently would be valued, at a cap rate higher than a similar type of property in a more strategic location.
It pays to be knowledgeable about cap rates for your type of property asset in your local marketplace!