By: LeAnn Hume, CCIM, CLS, is Senior Director – Retail/Investment Specialist with Cushman & Wakefield | Commerce email@example.com
Originally published in the Boise CCIM 2015 Directory, Read more here
If i had to pick the term most used in commercial real estate in the past 18 months, it would be “cap rate.” What is cap rate and what is its impact in terms of today’s commercial real estate market? It takes years of experience to truly be versed in cap rate as it relates to commercial real estate. Simply put, cap rate is the relationship between Net Operating Income on a property and the value of that asset. NOI/Value = Cap Rate.
Let’s use an example: a corporate fast food tenant selects a location to open a store in their chain. They sign a lease with a developer who will deliver them a building according to their specifications. In exchange for the use of that building, the tenant will pay that developer a lease rate for a negotiated amount of time. The Net Operating Income of that lease has value. Not only is it helping the developer cover his debt service on the expense he incurred in building that location for the fast food user, but also has an intrinsic value and a cap rate value. Let’s also say the fast food user is paying $120,000 per year for their lease (Net Operating Income or NOI). In addition, the tenant has agreed to maintain the property, pay the real estate taxes and the insurance on that property. And, they have agreed to be responsible for the roof and structure of that developer’s asset. The property is in a well-located area with great visibility, access and high traffic counts. The fast food user has signed a 15-year lease. Their corporate office that is publicly traded and has excellent financials has guaranteed the lease. Translation: that developer is sitting on a very appealing asset that is in high demand in current market conditions.
Why is it so appealing? There is a phenomenon occurring in our wonderful State of Idaho: out of state investors. Owners of good assets in California are getting an influx of both domestic and foreign investors who have created such high demand for United States property, that it has caused cap rates to compress to record setting levels. Here we are, back to cap rates. Concept: the lower the cap rate, the more valuable the property.
Take our fast food example. Given the criteria outlined above, it could be argued that this property in this market would command a 6 cap. What does that mean? $120,000 NOI at a 6 cap is a value of $2,000,000. Mathematically speaking: $120,000/.06. Using the same example, let’s say the tenant only signed a 5-year lease and it is not a corporate owned store, but a local franchisee with mediocre credit. To offset this increase in risk, the developer would most likely increase the cap rate to 8 percent. Same example: $120,000 NOI at an 8 cap is a value of $1,500,00. If that developer were to decide to sell the asset he just built for the tenant, he is essentially selling the income stream and real property of that fast food operation. Concept: the lower the cap rate, the lower the risk for the investor.
Who determines cap rates? The short answer is that the market ultimately determines the cap rate. Buyers and investors of these types of properties are ultimately the determiners of what a property is worth. Any CCIM should be capable of making an educated assessment of the cap rate that should be associated with a given asset. They take into account many factors such as demand, market rents, credit of the tenant(s), remaining lease term, structure of the leases, location, age of the asset and many other nuances that determine value.
Let’s go back to Economics 101. High demand, low supply equals higher prices. That applies to investment properties in Idaho and throughout the west. California property owners are selling their properties to foreign investors at 4 caps and have 1031 money that they have to invest in order to defer capital gains taxes. What are they going to do with that money? Go out into the pool of other foreign investors competing for properties in California? Or perhaps go to states like Idaho, Montana, and Oregon to find quality real estate with credit-worthy tenants and pay a 6 cap for the same income stream?
To simplify: if you are an investor with money to invest and you have a choice between buying a fast food restaurant in California that pays you $120,000 in NOI every year at a 4 cap ($120,000/.04 = $3,000,000) or the same fast food restaurant in Idaho paying $120,000 in NOI per year at a 6 cap ($2,000,000), you are paying less money for the same income stream. Concept: Investor and 1031 money is chasing yields throughout the country to increase their returns on investment.
When out-of-state money comes into our markets looking for quality investments, it increases the demand and therefore increases the price, which translates into lower cap rates than we have seen in the last 5 years. For sellers, this is great news. For buyers, the competition for quality assets is steep and your financial strength, amount of cash and ability to close quickly will set you apart in the pool of investors competing for quality assets. In our market, we are seeing deals like those described above dipping to the 5 cap range. Whether this is good or bad is in the eye of the beholder. Using the services of a knowledgeable CCIM adviser can help investors make sense of current commercial real estate market conditions and make wiser choices using expertise and sound real estate fundamentals.