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Value is in the eye of the CRE beholder: A cap rate primer

There is one thing universal to commercial real estate transactions when it comes to investment b...

There is one thing universal to commercial real estate transactions when it comes to investment buyers and sellers: buyers want the highest cap rate they can find and sellers want to challenge the market with the lowest cap rate it will withstand.

Often the value of the property lies somewhere in-between.

Buy high

A capitalization (cap) rate is the annual return on investment for a buyer. It’s not hard to contemplate why buyers are desirous of purchasing properties with high cap rates.

The more cash flow, the faster they can service the debt on the investment or improve their cash position toward the property.

The problem is this is pretty much the polar opposite of the mentality of sellers.

Sell low

Net income on an investment property doesn’t change when negotiating a cap rate. The income is what the income is.

A seller is going to get a higher value for their real estate if they can entice a buyer at a lower cap rate.

If you’re like me, a visual is huge to understanding this concept: Let’s say I have a building netting out $100,000 per year after hard cost expenses are paid. At a seven cap, that property would be valued at $1,428,572.

Shift that even half a point to a 6.5 cap, though, and the property increases in value to $1,538,462.

That $110,000 difference is significant whether you’re the buyer or seller.

Why would anyone buy at a low cap rate?

If the product has good tenants in a strong market, with favourable lease terms, there are buyers willing to take less return to secure the investment.

Commercial real estate investing is no different than any other investment in that regard. There are lower returns for investments which are deemed less risky.

Cap rates vary by market and by type

Commercial real estate investing is all about how hungry you are for specific product types.

This desire will, in many ways, be fuelled by your aversion to risk and how much risk you think you can chew.

It’s important to understand that there is no definitive guide by which to reference cap rates. As brokers, we can give you an idea of our opinion, but it’s often a range.

Cap rates are a moving target that can shift over the course of a few months depending on the economic climate.

I haven’t seen it in my career, but there are brokers in our office who can recall the good old days when cap rates were 12 per cent.

I’m sure we have several buyers who would be falling over themselves to get that type of return nowadays!

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