A capitalisation rate or cap rate is a quick way to estimate the potential return on investment on a commercial property.
While it’s considered the main method used by commercial valuers, be cautious when using it to assess the potential value of a commercial property.
There are many factors that influence the price you should be paying for a commercial freehold.
How to use the cap rate to assess a commercial property deal
The cap rate is useful but it can often be misused or relied on too heavily as part of the valuation.
The reason behind this is that it’s quite simple to calculate, providing you with an easily digestible return on investment (ROI) rate which you can compare with similar types of commercial property in the area and your own ROI goals.
How do I work it out?
The formula to calculate the cap rate is:
|Capitalisation rate =||net operating income|
|current market value|
Net operating income (NOI) can be found on the vendor’s income and cash flow statements and you should consider looking at annual NOI for the past 3 years to get an average figure.
NOI is the property’s return on investment minus the costs required to manage the freehold itself such as capital expenses (CapEx) (building repairs and maintenance), building insurance and property management fees.
It also excludes principal and interest payments on the commercial loan, tax, depreciation and amortisation. The NOI is what valuers call a “true” net rather than a gross net figure.
By working out the cap rate, you can then work out whether the expected return is worth the asking price for the property.
Another way you can use the cap rate is to work out what the actual market value for the property is.
By comparing the cap rates of comparable sales in the area, you can rearrange the formula like this:
|Market value =||NOI|
This is the same method commercial valuers use and it can give you some sway in the negotiation process with the vendor.
Example of using a cap rate
Sam is looking for some commercial office space to buy as a freehold investment.
He’s found an office for sale and it’s in a great location.
The market valuation has come in at $800,000 but Sam wants to know what his potential ROI is.
He knows the property needs some work and the current tenants only have 2 years remaining on their lease.
Based on the current rental income, the CapEx required and the revenue loss from an exiting tenant, the net operating income for the property is about $100,000.
Based on the formula, you’d divide $100,000 by $800,000 to arrive at a cap rate of 12.5%.
Based on comparable sales in the area, the cap rate is on par in terms of the size and location of the premises.
However, due to the strength of the current tenants and the fact that capital expenditure will cost him around $80,000, the cap rate is actually way too high.
What this means is that Sam is in a position to negotiate on the purchase price of the property.
For example, he might only decide to offer $720,000 for the property instead of $800,000.
What does it tell me about the property?
The cap rate basically tells you what your investment return will be on the property and how it compares to properties in the same location and of the same type and size.
Generally speaking, the smaller the size of the property, the higher the cap rate. The higher the rate, the higher the risk.
So how can the cap rate help me make a decision on the purchase?
Cap rate can identify risks and opportunities
As much as the cap rate is a measure on return, it essentially gives you an indication of the risk involved with the property.
In fact, the cap rate gives you the ability to identify issues that may later arise with the purchase such as a short-term remaining the lease or the fact that the tenants’ business is in financial trouble.
It can also tell you whether the current tenant is paying above market rent and whether that level of rental income is repeatable in the future.
For example, similar-sized warehouses in your area are fetching around $300 a square metre in weekly rent but the tenant that the vendor has is paying $350. There’s a risk that that level of rental income won’t be repeatable with the next tenant.
Depending on the level of risk you’re willing to take on, it may also present an opportunity to buy the property at a reduced price in the knowledge that you can turn the property around.
This could be by increasing operating costs or by increasing the rent, which is currently being charged at below market value.
Cap rate can identify market trends
You can identify the trends emerging in the sector by tracking the cap rate for retail property sales in Melbourne over time, for instance.
If cap rates are increasing, it may be an indication that the market is slowing down so you may want to consider buying now, at the bottom of the market in the hopes of a strong return in the future.
Of course, relying on historical data alone shouldn’t be the sole method in deciding whether to buy the freehold.
What are the benefits of using a cap rate?
The main benefit of using the cap rate is that it allows you to quickly compare the investment return of comparable properties really quickly.
It allows you to ask those fundamental questions you should be asking about the commercial property and quickly assessing the strengths and weaknesses of the purchase.
This way, you can decide whether to accept the risks or not and to see if there are ways you may be able to mitigate those risks if you decide to buy the property.
Above all, the cap rate formula is the industry standard for commercial property valuers.
What are the drawbacks?
The problem with relying heavily on the cap rate is that it assumes that revenue estimates are accurate and that the market value of the property will remain unchanged.
Put simply, the property is only valuable if NOI is increasing at the same rate or more than the property’s value.
With limited consideration for net operating loss, the cap rate also struggles when it comes to NOI that is irregular and so will require another measurement tool.
There’s also the issue of getting “like for like” comparable sales for the commercial property you’re looking to purchase.
This is quite unique to the commercial real estate space purely because there are less commercial properties then there are residential properties.
For example, the valuer might need to consider factories in the next suburb or the next town because it’s not likely you’re going to find the same three property types on the same street.
It may also be difficult to find comparable sales where transactions took place in the last 12 months.
Anything older than a year isn’t a comparable sale.
When should I not use the cap rate?
You’re leasing a property
The first and most obvious reason why you wouldn’t use a cap rate when valuing a commercial property is if you’re an owner occupier.
As a business owner, you’re not buying the property to make a capital gain and you’re not concerned with net operating income since this would be the concern of your landlord.
Your perception of value is totally different to someone looking to invest in a freehold.
Of course, if you’re buying the freehold as a going concern, the costs of building maintenance, repairs and maintenance etc. should be taken into account as part of your business due diligence.
In addition, knowing that the property is likely going to grow in value over the next few years (based on historical cap rate figures) should give you some comfort in the event your business venture experiences financial trouble.
When fundamentals don’t stack up
Although the cap rate takes into account many aspects of the property, there are other factors that influence the ultimate purchase price that don’t quite fit neatly into the capitalisation rate formula.
For example, a retail shop may have a particularly high cap rate based on the strength of the current tenants.
A reason for the high cap rate is that the current tenants may be coming to the end of their lease.
However, business is going well and they’re likely to renew their lease.
Even if they don’t renew their lease, you know from your due diligence on the location that the area is being developed by the local council into a retail centre.
Losing a tenant is clearly a risk but you may be willing to wear that risk because you’re confident in finding a new tenant.
The cap rate won’t cover all of the costs and potential revenue.
When it comes to using the cap rate to work out the actual market value for a freehold, you also have to keep in mind that you’re rarely going to pay market value for a property anyway.
You’ll almost always be paying a premium for any number of reasons including whether you’re in competition with another bidder or whether the area is being rezoned to support businesses locally.
Similarly, the final price you arrive at with the vendor will be by negotiation.
You don’t want to sell the vendor short and miss out on great future returns based on the cap rate alone.
On the other hand, you have to consider why the owner is selling in the first place: are they desperate and willing to move on price?
Is there a list of cap rates I can refer to?
There isn’t a central database of different commercial properties like offices, hotel, warehouses, factories and so on.
The reason is that cap rates are largely dependent on location, the strength of the tenant, the condition of the property and CapEx requirements.
The problem is also that cap rates can change over time so referring to a cap rate for a childcare centre from over 12 months ago, for instance, wouldn’t be accurate.
Cap rates are usually calculated by valuers looking at comparable sales in the area via commercial real estate websites like commercialrealestate.com.au as well as the valuer’s own existing book of business.
You can do the same or even check out the sales brochures of the local real estate agents.
They tend to only refer to cap rates that are less than 12 months old.
Do you need a commercial property loan?
We’re not valuers but we can help you qualify for a commercial property loan!
If you’re happy with the cap rate of a property you’ve found and you’ve undertaken further due diligence, get in touch with us and we can help you qualify for a commercial loan, whether you’re buying a freehold or need a business loan as well.
We have strong relationships with the commercial credit departments of a number of major banks as well as specialist lenders.
Because we know the key decision makers, we know how to build a strong case so you have a strong chance to get approved the first time around and even negotiate reduced commercial interest rates.
Call us today on 1300 889 743 or complete our free assessment form and tell us about the commercial property you’re looking to buy.