Capitalization rates, or CAP rates, are analyzed to provide both a buyer and a seller with some basic information on how commercial real estate value is based on the interest income that is generated by the property per year relative to the net investment. Although these valuations are only an estimate and may fluctuate from day-to-day based on real estate stocks, there is seldom a factor that is as debatable as the CAP rate when deciding to buy or sell commercial real estate.
Factors to Consider
One may wonder if CAP rates are a good way to assess commercial spaces. They may very well play a role in this assessment; however, the following factors should be carefully considered to achieve reliable results.
- Point of Reference – CAP calculations are valued against a benchmark of ten percent. Although it is feasible this to method of calculation to be used as a shortcut, the use of a generalized capitalization amount should be avoided. When it comes to the net worth of real estate, any minor fluctuation could lead to significant errors when making this calculation which could have huge monetary repercussions. As tedious as it may seem, rather than determining the approximate value of a certain property, it is much more advisable to thoroughly perform all calculations and then settle a representative value.
- Approximations – Many times, the data that is provided is an approximation. For commercial holdings, the monetary aspects of the property such as total income generation per year; percentage of vacancies; total amount of yearly expenses; and NOI sheets should never be an estimate; these figures should be exact. When considering the purchase of a commercial property, a buyer should not be satisfied when the language that is used to describe the financial aspects of the property is in the form of an estimation, such as an income of “around” $5,000,000.00, with a vacancy range of “approximately” six percent and an income-expense ratio of “about” thirty percent. Buyers should steer clear of real estate where the sellers are unwilling to provide exact figures for appraisal purposes.
- CAP Rate Components – While these rates do include some valuable data, they do not account for the business value portion of commercial holdings. When both the real estate and business price of a property is placed up against the real estate price of the property alone, the results may vary. Therefore, the income and expenditures in terms of the real estate itself as well as the actual needs of the business must be determined in order to evaluate the true worth of the property, something that the CAP fails to do.
- Historical Projections – The capitalization rate symbolizes monetary returns for investments for the coming financial year; however, these predictions are based on historical data which has been computed with the past financial year in mind. This system is flawed and provides inconsistent and changing monetary patterns. For instance, the CAP rate chart does not account for any sudden variations in the real estate or stock market. The fact that these rates depend on the previous years’ calculations to provide for the future has the possibility of causing huge problems down the road.
- Confusing Figures – CAP returns can be confusing and are based on charts that determine the equity returns for a range of initial investments and amounts. For instance, an investor who spends $475,000.00 for a commercial holding can expect to receive equity ranging anywhere from 7.4 percent to 24.8 percent, depending on capitalization rates over a twenty-five year period. Therefore, investors have no sure bankable assets with which to determine the worth of the property at a given period in time and must always “assume” the average.
CAP rates can be a very deceptive means of determining the value of a property. Buyers might determine that properties with low capitalization rates are much more profitable in comparison to those with high ones; in fact, these amounts may change from year to year. As a final word, it is not a good idea for buyers to completely base a decision on whether to purchase a certain commercial space based on the CAP value alone!