Cap Rate Industial Vs Office Vs Multires Vs Commercial

[leasedfee]

You put 1 million, and you get 100 000$. It means a return of 10%. How can you argue with that?...Am I missing something here..?

You're missing the reversion value. You're missing what happens to those cash flows over time. What if a building only has a 7 year interim use, then demolished, and then...? Mathematically, you have an infinite possibility of outcomes to a property/asset based on a value of $1 m. and a 10% cap rate.

Cap rates are simply an algebraic compression ratio (my term) of all of the financial information contained in a discounted cash flow analysis. As another poster explained, it is just a ratio of value to first year income. (If the first year income isn't stable, and the income isn't level, uniform, or consistently increasing, your cap rate is particularly wild and un-insightful for comparison against other properties.) Yield rate is more important than cap rates as a property is an income producing asset.

If you want to understand what is being "compressed" into the cap rate then study the following:

• Property Model {Y=R+delta x A};
• K ratios, and J ratios for the Property Model
• Ellwood model;
• Band of Investment;
• Banker's Ratio Model, aka Debt Coverage Formula;
• conventional DCF analysis;
• Inwood/Hoskold models.
• Net Uniform Series
• Plus, building/land residual models.

This is an excellent book.

http://www.amazon.com/dp/0922154589/?tag=realestatappraat

What drives a cap rate? Well it is competition between each of these models above. Each of the variables contained therein in the real world are basically competing against each other and forcing themselves into equilibrium.

In my area, industrial cap rates have been lower than office and retail cap rates for some time. P.S., I don't agree with your adviser saying a 100% cash purchase is the cap rate return. A better definition, in my opinion, is that a "capitalization rate is value." (The reciprocal of value, that is, for the math oriented.)

 

[Ken B]

The text Leasedfee references is good for understanding the mathematical "how", but not so much the "why" of the differences between market segments. Then again, explaining the "why" can be a challenge when the market is behaving irrationally, as it does when bubbles are created.

 

[leasedfee]

One of the reasons why bubbles form is that overly optimistic (delusional) investors over-estimate the growth parameters of their DCF, and downplay the loss parameters of the DCF. Even if they don't do a DCF, and solely rely on direct cap, they are equivalently doing the same when they say they'll out-bid their competition by paying a lower cap rate, "after-all the future is so bright, you gotta pay it to be in the game no matter the price."

Valmont, another reason cap rate isn't a true measure of return as your adviser posited is that if the first years NOI is 50% of stable, or zero NOI, or negative NOI for a vacant property, then the cap rate would be about 5%, 0%, and negative -- yet all three investment scenarios could have a 10% yield rate, and values at or near the $1 million.

 

[George Hatch]

We use the term "cap rate" in casual conversation a lot, but appraisers understand that another term for it is "overall rate". As mentioned above, that rate includes a lot of implicit assumptions, each of which can and do vary under different scenarios.

As has been mentioned above, your $1M/$100k = 10% cap rate could mean any of several combinations of assumptions. It could mean a long term lease encumbrance that inhibits the income potential in a market where 8% is more typical, or it could mean an extra strong lease with excess rent in a market where 13% cap rates are more typical. It could mean more vaule attributable to the underlying land and less to the existing improvements. It could mean more value attributable to the lessor's interest or more to the lessee's interests, depending on how the terms of the lease stack up to the prevailing market rents.

Lots of moving parts, which is why we tend to be pretty careful about not directly comparing as if equal the cap rates from properties with different uses or other significant attributes.

 

[WestMichiganCG]

I think the easiest way to wrap your mind around cap rates is to think of it as a measure of risk. In my area there is less risk for apartments as they are in lower supply and higher demand. I have derived capitalization rates in the low 8's based on sales and income information. Offices are in high supply and lower demand and could be in the 10's for the lower end of the range and 9's or lower for medical office as the tenants associated with that office space sign long term leases and the medical clients are typically less likely to break a lease. Industrial space has been in short supply with capitalization rates in the 9's with the exception of out of area rural industrial which has been hurt because of the distance from the expressways. This distance messes with the just-in time model of delivery for some manufacturers. I have seen special use properties such as golf courses and car washes up in the 13's or higher because of the lower demand and higher risk associated with a business that people consider to be a want, not a need. Another area where I have seen lower cap rates is below market rents. An apartment with below market rent is less likely to loose a tenant, therefore there is less risk associated with that income stream. If the tenant moves out, a higher income stream could quickly be found by replacing the tenant with a market rate tenant. My understanding stems from deriving the capitalization rates from appraisals where I had the income from an owner and its corresponding sale shortly thereafter. The questions you ask are good ones. The next step is to get inside the mind of an investor, talk to them and ask them how they determine the capitalization rates they use. Understanding yield rates, going in and going out rates, delta's, discounted cash flows and reversions is important. If I'm doing a complex discounted cash flow analysis, I'll always convert it to an equivalent direct capitalization to make sure it makes logical sense.