For many people, the primary purpose of investing in commercial real estate is to generate rental income. Knowing a property's net operating income (NOI) can help you to estimate the property's value. However, knowing NOI is not enough to determine a property's value; you must know the risk associated with the cash flow coming out of the property. For example, if you knew that two properties had the same NOI, you could not determine which property was a better investment. You would also want to know about the property's location, type, and condition, as well as the credit quality of the tenants.
Consider the following scenario: Property A and Property B both have NOIs of $1M. Property A's selling price is $20M, and Property B's selling price is $10M. Property A is in Phoenix's central business district, whereas Property B is in a small town located 150 miles from Phoenix.
If the income from downtown Property A is the same as the income from small-town Property B, is Property A worth twice as much as Property B? All else being equal, future income of a property in downtown Phoenix is more certain than the future income of a property in a small, remote town. To determine if Property A is, in fact, worth twice as much as Property B, you need to quantify the risk associated with both properties.
A property's capitalization rate (also called a "cap rate") is a metric of risk. The cap rate is the rate of return that an investor will require to own a particular property. A higher rate of return - in other words, a higher cap rate - is associated with greater risk. The greater a property's risk is, the less an investor is willing to pay for the property. You can see this relationship in the cap rate formula:
Cap Rate = NOI / Property Value
or, rearranged,
Property Value = NOI / Cap Rate
The higher the cap rate, the lower the value. Likewise, the lower the cap rate, the higher the value. To see this relationship in action, consider Property A in downtown Phoenix and Property B in small-town Arizona. Both properties have the same NOI, but Property A is worth more because there is less risk involved in obtaining its income. To determine just how much more Property A is worth, you can use cap rates.
When using cap rates, it is a good idea to use the cap rates that are derived from the sale of comparable properties ("comps"), or the data services (e.g., PricewaterhouseCoopers, Integra Realty Resources) that are used by professional appraisers. You should also consider your personal goals for investment returns. For example, if comps in downtown Phoenix showed cap rates ranging from 6.5 percent to 7.5 percent, and the cap rate for downtown Phoenix properties of Property A's type (e.g., office, industrial) was 7 percent, then with the property's NOI of $1M, you can estimate that a fair selling price for the property would be approximately $13.3M to $15.4M. The $20M selling price in the original scenario would likely be too high. In the case of Property B, it might be difficult to find comps or appraisal information for properties in small towns, so it is important to consider the cap rate you would find acceptable. The riskier the revenue stream from Property B, the higher the return (cap rate) should be, and thus, the less you should pay for the property. For example, if you want to achieve a 12 percent rate of return for the small-town property with a NOI of $1M, you should pay approximately $8.3M for the property. The hypothetical sales price of $10M would be too high, unless you were willing to accept a 10 percent cap rate.
"When buying or selling commercial real estate, it is important to consider both personal expectations for investment returns and demonstrated cap rates from comps," said Jack Rose, Chief Strategist at Breakwater Equity Partners. "However, if good comps are not available, various appraisal groups, such as PricewaterhouseCoopers', have guides investors can use to estimate fair prices." In addition to using cap rates, many commercial real estate investors employ advisory firms to build financial models, which can inform investors' decisions. Whether you are considering purchasing or selling commercial property, quantitative research will help you to negotiate the best deal possible.