Cap Rates and Commercial Loans II

This is my second article for commercial loan brokers and commercial investors about cap rates.  In my last article we described how a Cap Rate is simply the return (think of it like "interest") that an investor would earn if he bought a commercial property for all cash.

Algebraically, the Cap Rate is the property's Net Operating Income (NOI) divided by the Purchase Price, multiplied by 100%.  Let's use a simple example to solidify this ratio in your mind.   Let's suppose an investor bought a small, average-quality, office building with a NOI of $50,000, and he paid $700,000 for the property.  Fifty thousand dollars divided by $700,000 is 0.071.  (Remember that Cap Rates are computed without regard to any commercial loan placed on the property.)

Multiplied by 100%, we have a Cap Rate of 7.1%.  Cap Rates are commonly expressed as percentages, to one digit.  Therefore Cap Rates look like this:  8.2% or 5.6% or 11.8%.

Not every investor will be satisfied with the same Cap Rate.  Let's go back to the above example, and now let's assume that a wealthy business owner is leasing one of the six office suites in the building.  In addition to partially-occupying the building, this wealthy business owner lives just five minutes away.  He likes the short commute, and he fears that he might someday be forced to move.  When he hears that the office building has been listed for sale and that an offer to buy the property has already been made, the wealthy business owner submits a competing offer for $740,000.

Just for practice, let's compute the wealthy business owner's new Cap Rate.  Fifty thousand dollars in Net Operating Income divided by the higher, $740,000 purchase price gives us 0.67.  Multiplied by 100% gives us a 6.7% Cap Rate.  Obviously the second guy's Cap Rate is lower because he paid $40,000 more for the same $50,000 worth of Net Operating Income.

So what are some common Cap Rates on average-quality buildings in middle-income areas?

Multi-family

6.0% to 8.0%

Office

7.5% to 9.5%

Retail

7.5% to 9.5%

Industrial

8.25% to 10.25%

Hospitality

9.5% to 11.5%

Here are some general rules about Cap Rates:

1. The nicer the area, the lower the Cap Rate.  Average-quality buildings in the wealthiest part of town commonly sell at Cap Rates of 6.5% or lower.
2. The more reliable the income stream, the lower the Cap Rate.  For example, an office building with a 20-year lease from Apple Computer might sell at just a 4.5% Cap Rate.
3. The more vacant land surrounding or close to the property, the higher the Cap Rate.  The reason why is because if rents ever increase too high, some developer will quickly throw up a competing building.
4. Buildings in successful downtown areas sell for absurdly low Cap Rates - sometimes as low as 3.5%.
5. The younger the building, the lower the Cap Rate.

We can therefore tell a lot about a building, just by its cap rate.  For example, if you tell me that I can buy an apartment building at a 14% Cap Rate, I would pretty much bet that the area suffers from pervasive drug use, a high crime rate, and gang violence.

If you tell me that an industrial building just sold for a 7.0% Cap Rate, I would bet that the property is less than seven years old, has tall ceilings (important to a modern warehouser, who stack pallets very high), and a stronger-than-average tenant.

If you tell me that an office building just sold at a 5.0% Cap Rate, my bet is that the office building is located in an upper-income downtown area with virtually no vacant land within a mile (prevents competing buildings from being built).

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