Probably the single most useful and simultaneously ill-used tool to determine the price of an investment is the capitalization rate (or “cap rate”). The term is often used to cover a range of price estimation techniques which seek to link value to an income stream by estimating the amount of capital an investor would be willing to part with to purchase that income stream.
One important consideration to keep in mind when you are being quoted or quoting a cap rate is that it is market driven. In order for it to be calculated correctly, it is more important to use relevant data for the market area than the data for the property itself. This does not simply mean the obvious: that comparable sales should be used to determine cap rate. It is just as important to make sure that standard techniques and market rates are used to evaluate the net income.
Some questions to ask:
(1) When calculating net income, was market vacancy rate used?
(2) Was economic vacancy considered? Economic vacancy is the effective vacancy after such things as signing bonuses and incentives are accounted for. For example, if the standard market practice is to offer new tenants two months free rent, and you expect full tenant turnover every five years, you will be losing 2 out of every 60 months’ rent - in a simple example with uniform lease rate per square foot, this corresponds to an additional 3.3% vacancy.
(3) Was the net income effectively normalized? Was management salary and costs included? For a building, expect that a management firm may charge between 5% and 8% of the gross revenues as a management fee; for a business it is standard to deduct $40,000 to $80,000 for manager’s salary from the net income, if such provision has not already been made.
(4) What comparables were used to generate the cap data? How indicative are these comparables of general market trends? Some types of business or real estate are so unique that it may be impossible to find comparable data on which to base your risk estimates.
Once the correct market information, where available, has been used in a proper manner, different methods exist by which rates may be used to calculate the value of the real estate.
There are three methods which are commonly used:
(1) Straight Cap Rate: the normalized net income is divided by the annual fractional rate of return that the market data indicates investors will pay, on average, for that size of income stream and risk. In business sales, a “cap multiplier” (inverse of the cap rate) may be used. This method is the standard used for most sales of income producing property where revenues are expected to remain stable over the near to mid future - a good example would be mobile home parks or commercial buildings in the prominent business corridors.
(2) Discounted Cash Flow: In a situation where revenues may be expected to fluctuate in the near to mid future, a strict cap rate based on current revenues and market data will not give an accurate estimate of value. The DCF method requires first a reasonable estimate of future income; the income is then discounted and averaged before a cap rate is applied. Because 3000+ pre-sold suites will be built over the next two years, Vancouver Multi-Family owners can expect to see the vacancy rates, already at 30 year highs, continue to increase. By estimating the effect of these suites on the tenant pool as they are completed, such investments may be more accurately valued.
(3) Excess Earnings Method: Among the investment classes we transact, businesses show the greatest diversity of characteristics. Often it is useful to be able to separate the revenue streams produced by a business into regular and excess earnings. Regular earnings is that portion of the income which may reasonably be said to be the derived normal return on the net assets. The balance of the income would be used to derive the value of “goodwill” and other non-typical assets of the business. A typical rate for the regular portion of the income would fall in the 6% to 9% range; rates for the excess earnings tend to be much higher; a reflection of the increased risk.