How Capitalization Rates affect Market Value of Commercial Real Estate

Capitalization rates (or cap rates) is a factor used to determine the market value of commercial property for a known net rental.

It provides a comparative measure for investors to roughly estimate market value a property based on its income. It reflects the yield on a property which is another word for return on investment.

The formula for Cap rate is:

Cap rate(%) = Net Annual Rent / Value of Property

A more useful derivation of the formula above is used to determine the value of a property based on a Cap rate:

Value of Property = Net Annual Rent / Cap rate(%)

For example if the net rent from a property is $100,000 and the prevailing cap rate for this type of the building in the area is 10% then the value of the property will be:

Value of Property = $100,000 / 0.1 = $1,000,000.00

As an investor you have to have very clear understanding about the relation between property value and capitalization rate.

As the Cap rate increases the value goes down and when the Cap rate decreases the value goes up. Please see below values calculated for the above building netting $100,000 at different capitalization rates:

Cap Rate 7% : Value = $100,000 / .07 = $1,428,571
Cap Rate 8% : Value = $100,000 / .08 = $1,250,000
Cap Rate9% : Value = $100,000 / .09 = $1,111,111
Cap Rate 10% : Value = $100,000 / .10 = $1,000,000
Cap Rate 11% : Value = $100,000 / .11 = $909,091
Cap Rate12% : Value = $100,000 / .12 = $833,333

By the same formula if the market rent was to decrease the value of property will decrease.

It is important to remember that same rent can produce different values for property depending upon the Cap rate applied.

So to determine the market value of a property you are buying you have to first determine the correct market rental for the type of property and also know what Cap rate to apply for a given building in a particular location.

It is therefore critical that you know and understand the factors that affect capitalization rates.

Factors that Affect Capitalization Rates

• Term of the lease - Longer the lease lower the Cap rate. If the building is vacant the applied cap rate will be high. As soon as you sign up a good tenant the cap rate will reduce immediately. As the lease term runs out the cap rate will start moving up again.
• Quality of the tenant - There is no point in having a long lease if the tenant is not strong. National tenants like banks, Shell or BP will cause valuers to apply lower Cap rate when determining value.
• Type of property - Different types of property will command different types of cap rates. For instance if commercial properties have larger vacancy rates when compared to retail then a retail property will command lower cap rates.
• Location - Properties closer to the city center and in prime areas will have lower cap rates as vacancies are low. Properties in smaller towns will normally have higher cap rates because of the difficulty in finding new tenants in case of a vacancy.

How to Shift Capitalization Rate

You can shift Cap rates in your favor and increase the value of the property by doing any of the following:

• Negotiate better Lease Terms - If you are not able to increase the rent then try and get better terms for the lease. Increase the length of the lease, get personal guarantees from the tenant, ensure out goings are fully covered, more frequent rent reviews at market or CPI which ever is greater, have a full ratchet clause, get the rents closer to market rental.
• Change Use - Change use to higher value. For example convert warehouse space into retail or office. Apply for change of land use or zoning.
• Carryout improvements and renovations. Add new services.
• Improve entry and exit points - Improving transport access helps.
• Add Car Parks

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