How Capitalization Rates Affect Market Value of Commercial Real Estate?

by James Olson
(United states)

Question: In your article "How Capitalization Rates affect Market Value of Commercial Real Estate", you state "Longer the lease lower the Cap rate". Is this an intuitive statement or do you have proof/sources that support the statement?

Answer: This is not an intuitive statement. Let us say for example there is a commercial property returning $80,000 net pa. If the lease on the property is expiring let us say after one year then there will be very few investors who will be willing to pay a premium price for such a property due to the risk of finding a new tenant. Such a property will be sold for a price of $800,000 reflecting a return of 10% on the investment.

Alternately if the same property had a long lease of 9 years then investors will be willing to pay a premium as the risk involved will be minimal and it will be easier to get bank finance. In such a case the property will most likely be sold for a higher price of $900,000 to $1.0m reflecting a return of 8 to 9 percent.

You will see in this example that the cap rate goes down with the length of the lease. This example is true for investors. However in case of owner occupiers/ property developers length of lease lease can be handicap. Owner occupier or a developer will pay a premium if the property can be vacated in reasonable time so that they can put to better use.

Cap rate is dependent on several other factors as discussed in the article http://www.real-estate-investment.net/capitalization-rates.html