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Silicon Valley Commercial Real Estate Office Update
What is Cap Rate?
The capitalization rate (aka cap rate) is defined as the first year “stabilized” net operating income (NOI) divided by the present value (or purchase price).
What is the Advantage of Using Cap Rate to Analyze an Investment?
The cap rate is a convenient and quick method to determine if the value or purchase price of an investment meets the investor’s criteria. The cap rate alone, however, should not be the sole reason to purchase a property. Investors must perform proper due diligence and consider other factors such as location, demographics, growth, supply vs demand, loan-to-value and debt coverage ratios to determine if an investment is worth the risk.
What are the Disadvantages of Using Cap Rate to Analyze an Investment?
The main disadvantage in using the cap rate to analyze an investment property is that the cap rate only shows the value of a property based on the first year’s stabilized net operating income. If the NOI of a property changes in subsequent years, the cap rate changes, therefore the value. The cap rate has an inverse relationship to value. Assuming the NOI remains the same, if the cap rate increases, the value decreases and vice versa.
Is it Better to Have a Low or High Cap Rate?
The answer to this question depends on who is evaluating the property. Investors (buyers) want a high cap rate, meaning the value (or purchase price) of the property is lower. Conversely, landlords (sellers) want to see a low cap rate which reflects a higher selling price.
Cap Rate Example (Which is a better deal?)
In the example below, which is a better deal?
Property A has a cap rate of 8.74% and Property B, 8.06%. Clearly, the return on equity is higher for Property B. Why is that so?
Let’s take a look. Even though Property A has a higher net operating income (NOI), the interest is higher. Many factors affect the interest rate which results in a lower investment equity return.
Factors such as loan amount, property type, age of the property, tenant, location, credit history, economic condition, etc all play a significant role in determiningg appreciation rate, and ultimately value, of commercial properties.
Therefore, The Ivy Group recommends that before investors rush out to purchase a property, do not just analyze the investment based on the cap rate. Give us a call and we will perform the proper due diligence so that sound decisions are made based on real data.
$3M, 8.74 % cap rate
$3M, 8.06 % cap rate
|Net Operating Income (NOI)||$251,940||$241,680|
|Loan Amount (60% LTV)||$1,800,000||$1,800,000|
|Down Payment (40%)||$1,200,000||$1,200,000|
|Loan Interest Rate||7.00 %||6.00 %|
|Annual Payment (P & I)||$152,664||$139,169|
|Income Before Tax||$99,276||$102,511|
|Investment Equity Return||8.27 %||8.54 %|
Have you ever wondered what type of commercial real estate leases are best for the landlord? What about the tenant? Below are the different types of leases for your consideration.
|Fixed – Full Service – Flat Lease||Tenant pays a base rent only, all expenses, including the tenant use of utilities, are paid by the landlord.||Typically used in large office buildings.|
|Gross Lease||Tenant pays a base rent and all expenses are paid by the landlord. However, tenant pays its own use of utilities, like gas and electric.||Typically used for office/retail buildings.|
|Modified Gross Lease||As name implies, a modified lease is a Gross Lease but “modified” to pass-through certain expenses to the tenant, like janitorial and repairs, or others negotiated before signing the lease.Modified Gross lease is also used when landlord bills tenant for “increases” of expenses from base year.||Typically used in medical and industrial buildings.|
|Net Lease||Tenant pays a base rent plus some or all operating expenses for its percentage share of property (prorata).If it is a Single Net Lease (N), tenant pays base rent plus one of the operating expenses, either property tax, Insurance or CAM charges.In a Double Net Lease (NN), tenant pays base rent plus two of the operating expense, usually Property Tax and Insurance.In a triple Net Lease (NNN), tenant pays for all operating expenses. Most of the time, in a NNN lease capital improvements, such as new roof, will not be billed back to tenants.||Typically used in retail shopping centers.|
|Absolute Triple Net (NNN)||Tenant pays base rent and pays all the operating expenses including capital improvements. In this type of lease, landlord doesn’t even see the bills; tenant pays the property tax, insurance, CAM and capital improvements directly to vendors.||Typically used in Single Tenant properties and Sale-lease back transaction with long leases.|
|Ground Lease||Another version of Absolute Triple Net Lease where the landlord leases the ‘grounds’ only, technically the building belongs to the tenant, when lease is over the building “reverts” back to the landlord. In this scenario, the tenant gets to depreciate the building not the landlord.||Typically used for single tenant property.|