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CITY INVESTOR LEARNING CENTER |
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MESSAGE FROM BROKER/TOC
A. MEASURING AND COMPARING
INVESTMENTS
B. REAL ESTATE FINANCE
C. PURCHASE AND SALE ISSUES
D. LEASE LINGO AND LEASE NEGOTIATION
ISSUES
E. TAX ISSUES
A. MEASURING AND COMPARING INVESTMENTS
1.
Why Do Investors Often Talk About “Cap Rates”? What
Does a Cap Rate Measure? How Is It Calculated?
The phrase “cap rate” is shorthand language
for “capitalization rate”. The use of “cap rates”
is widespread in the real estate investment industry. This measure
is popular because it is relatively easy to calculate and because
it is commonly understood by most investors and real estate professionals.
To determine the capitalization rate of a potential investment,
use the following formula:
| Capitalization Rate
= |
1st Year Net Operating
Income |
|
| Purchase
Price |
A capitalization rate is essentially a calculation
of the first year rate of return of an investment.
2.
Can a “Cap Rate” Ever Be a Misleading Measure? When
Should I Be Careful When Using a “Cap Rate” to Influence
an Investment Decision?
Yes, a “cap rate” can often be a misleading
measure. Here are some common flaws:
- Common “Cap Rate” Flaw
#1: The lease is about to expire! Perhaps the most
notable limitation of a “cap rate” is that this measure
only serves as a current snapshot of the property’s first
year rate of return. A “cap rate” will be a misleading
measure where the income generating power of a property is expected
to fall off significantly in the future (e.g. upon the expiration
of the current lease). It is also true that a cap rate can sometime
under-estimate the rate of return, especially where a lease calls
for large rent increases in the future.
- Common “Cap Rate” Flaw
# 2: The advertised “cap rate” is
based on inaccurate “net operating income” data. Net
operating income (or “NOI”) is the annual income generated
by a property after deducting all expenses necessary to the operation
of the property that are the responsibility of the property owner.
Unfortunately, we are not very far removed from the bookkeeping
abuses of the Enron era. Investors should be wary that a seller
may have “cooked the books” to classify certain expenses
as one-time special charges rather than operating expenses. Thus,
it is always good to focus on the ultimate cash generated by the
property, rather than on theoretical accounting concepts of income
generated by the property.
- Common “Cap Rate” Flaw
#3: What about appreciation in value?
Because a cap rate is really only a current financial
“snapshot”, it does not factor in the potential impact
of appreciation in value. An investor might be willing to accept
a very low cap rate if they believe the property is going to appreciate
rapidly in value. For instance, resort properties often trade
at very low cap rates because of anticipated appreciation. It
should be noted that cap rates also do not factor in potential
declines in property value. Investors often forget that real estate
can decline in value!
3.
Are There Any Alternative Measures That I Can Use If I’m Not
Satisfied With the Accuracy of a “Cap Rate” for Analyzing
a Particular Investment?
Yes, there are numerous measurement tools
available that factor in the impact of future changes in rent, appreciation
or decline in value, interest rates, loan amortization periods,
closing costs, tax issues, and many other variables. Harbor City’s
commercial real estate professionals can review a particular investment
and determine the investment analysis tools that are most appropriate
for your potential investment.
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