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Capitalization (CAP) Rates

Discussion in 'Commercial Property' started by Chilliblue, 16th Jul, 2015.

  1. Chilliblue

    Chilliblue Well-Known Member

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    What is a Capitalization Rate?

    Whilst the capitalization (or its commonly used abbreviation CAP) rate is important in commercial real estate, cap rates are commonly misunderstood and sometimes incorrectly calculated.

    Assuming an all cash purchase, the cap rate represents the percentage return an investor would receive.

    Essentially the cap rate is the ratio of net operating income to property asset value.


    An Example:

    If a property was listed for $1,000,000 and generated an net operating income of $100,000, then the cap rate would be calculated as:

    $100,000/$1,000,000 = 10%


    Why Use a Cap Rate?

    Cap rates are useful for the commercial property investor as a tool to quickly sum up a potential purchase and allow an overview comparison as to which property may pose as a riskier purchase.

    Cap rates may also be used as a historical trend to highlight where the market may be heading. If cap rates are compressing then values may be heading upwards.



    Why NOT Use a Cap Rate?

    Cap rates should not always be used as a blanket property evaluation tool. Where a property has a varied and/or inconsistent income stream a discounted cash flow analysis should be undertaken.
     
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  2. Pistonbroke

    Pistonbroke Well-Known Member

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    I am a strong believer of the dcf as the primary analysis tool, the cap rate is your guide.

    Although dcf is not infallible and can be wildly inaccurate if periods are incorrectly assessed.
     
  3. Frode

    Frode Member

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    Resurrecting an old thread - I'd be very interested in seeing an example of how to do a Discounted Cash Flow calculation for a commercial property.

    If, for simplicity's sake, we have a property listed at $1m, with annual net rent at $50k, and rental increases of 5% every two years of a brand-new 10 year lease, what would a DCF calculation look like?

    Would anyone who know this mind showing the working for this? It's a purely hypothetical example, so please feel free to make up any other bits of information you need to make it work..

    Thanks in advance!
     
  4. Beano

    Beano Well-Known Member

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    All my registered valuations DCF as one of the calculations
     
  5. Frode

    Frode Member

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  6. Ross Forrester

    Ross Forrester Well-Known Member Business Member

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    It's important to note the cap rate is not the rate you receive when you buy as you will incur stamp duty.

    Also I see some properties sold with mid-term leases to associates of the vendor. So you buy and the tenants walks on the next renewal - or the lease itself has no director guarantees from the tenant so it all just goes pear shaped.

    Anyway. Cap rate is still good for shop talk.
     
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  7. Scott No Mates

    Scott No Mates Well-Known Member

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    The most important point is made around 8:35 - this is a primary methodology AND YOU MUST USE ALTERNATIVE MODELS.

    I extend this work to calculate the IRR to ensure that it meets company objectives.

    Pretty much the way I was taught when valuing equities (the other videos would be good to see for equities valuation as well - eg calculating WACC etc)

    That is a very abbreviated sheet - google Norman Harker (retired lecturer at WSU, valuer and Excel Guru - he still teaches valuers in their CPD specifically on use of excel for DCF & IRR)

    Cap rate is only passing yield ie Net rent/Purchase cost but as pointed out above means nothing if the tenant bails.

    More useful is market yield ie Net market rent (including effect of incentives)/Purchase, however this again is only a snapshot of the numbers at the time of DD or purchase.

    I have seen plenty of sites sold with a tenant in place only to qualify for purchasing as a going concern (for GST purposes).
     
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