We Appraise Both Businesses and Real Estate

August 2008

Capitalization Rates and Risk

Last month, I discussed the difference between business and real estate capitalization “cap” rates.  As a follow up to the topic of cap rates, I thought it would be useful to discuss cap rates and how they relate to risk.  This is easiest when discussing real estate, but the same principles apply in business cap rates and discount rates.

Again, just what is a cap rate and what does it measure?  A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon.  In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), and what the buyer expects from an eventual sale of the property.  It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation!  Cap rates change over time based on overall economic conditions, national and local, and they are particularly influenced by prevailing rates of return on alternative investments as well as the perceived risk associated with the specific real estate property.  

A number of factors should be considered when selecting a cap rate to be applied to a specific property in order to obtain an indication of value.  It is not simply enough to look at cap rates from the sale of other properties in the same category as the property in question, however, this is often all that is done in practice.  In order to understand how this should work, looking at an example will be helpful.  

Let’s assume we are valuing a small neighborhood shopping center with 10,000 square feet of building – five tenants each with 2,000 square feet of space, built last year, and located on a busy street in a nice town across from a Wal-Mart.  The “subject” is fully leased with one national tenant, one national franchise restaurant (local franchisee), and three “mom and pop” local businesses.  Each lease is for five years and is at “market” rent.

The following are a number of “comparable” sales that could be used to extract a capitalization rate that would be considered applicable to our subject:

If these are all of the sales that have occurred in the last year or so, it may be all of the information available.  What is the appropriate cap rate for the subject?  A tough question.

To further complicate things, cap rates that are extracted from sales are based on the income and expenses associated with each sale.  It is important to consider the vacancy rate used and whether or not the expenses used to arrive at each cap rate included all appropriate expenses or whether they may have been higher than normal for a number of reasons.  Often, there are a number of unknowns involved which could result in differences in cap rates derived from sales comparables.

The selected capitalization rate used to value a property is driven by the risk associated with achievement of the expected income stream.  Factors that influence the risk are the quality of tenants, the length of leases, the relationship of rents to current market rents, i.e. are the rents above the market rate? (If so, the tenant may be looking for ways out of the lease).  Are the rents below the market rate?  (If so, how long are the leases?  Are the leases assignable?)  What is happening in the area?   Many more factors are often considered as well. 

Once the capitalization rate has been selected, its suitability can be checked by a technique called the Band of Investment approach.  This methodology involves the use of typical rates of return on equity and available financing for similar properties.  If the indications of a suitable capitalization rate vary significantly from the capitalization rate extracted from the market, it may mean that additional considerations are warranted to see if perhaps the extracted rate should be adjusted.

The capitalization rate is very sensitive.  A small change in the cap rate results in a large difference in the indication of value.  For this reason, it is wise to use both a cost approach and a sales comparison approach to support the value conclusion reached using the income approach.  The appraiser’s judgment and experience greatly influences the quality of virtually all valuation conclusions reached. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses including machinery & equipment. 

July 2008

Business vs. Real Estate Cap Rates

It is not uncommon to see an inexperienced business appraiser, particularly one who has a real estate background or is familiar with commercial real estate properties, use a real estate capitalization rate to value a business entity.  When this occurs, the business is typically significantly overvalued. 

For many years it seems like the capitalization rate (cap rate) that was used for many real estate commercial properties was ten percent.  It is still used as a “rule of thumb” by many real estate brokers and property owners.  Over the last few years, we have seen cap rates in many real estate appraisals drop significantly from this old bench mark resulting in higher values.  Now as real estate financing has tightened up, cap rates are rising resulting in somewhat lower values as investors are demanding higher returns.  

Just what is a cap rate and what does it measure?  A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon.  In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), and what the buyer expects from an eventual sale of the property.  It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation!  Cap rates change over time based on overall economic conditions, national and local, and they are particularly influenced by prevailing rates of return on alternative investments as well as the perceived risk associated with the specific real estate property.  

The income stream used