Use of Cap Rates for Transaction Pricing

The capitalization rate or overall rate (OAR) is a fundamental metric used by investors, brokers, and lenders to determine transaction pricing (the price at which the deal gets done).  The cap rate is determined by dividing the NOI by the transaction price or projected value (cap rate =NOI/value).  Moreover, a property value can be determined by dividing the NOI by the cap rate (value = NOI/cap rate).  The cap rate can be viewed as an inverse measure of asset value per dollars of earnings (Geltner, p. 18). Cap rates are market and asset-specific and are determined by the following three factors of capital supply and demand.

• Risk:  How do investors perceive the level of sector-specific real estate risk at any given time?  If the market risk is perceived to be low, investors will pay more for a dollar of earnings, compressing cap rates.  Conversely, if perceived market risk is high, investors will demand/expect a higher ROI, driving cap rates up and prices down.
• Growth expectations: Real estate investors attempt to forecast future supply and demand in the space market, and their perception of growth influences cap rates as investors will pay more for an asset when they believe demand for space will increase, driving prices up and cap rates down.  Conversely, prices decline and cap rates rise when investors believe future demand for space will contract.
• Opportunity cost of capital:  Real estate investments are competing with securities and bonds for investors’ dollars, and investors are cognizant of bond rates and borrowing costs and will pay more for real estate assets when bond rates are low, pushing yields down (cap rate compression) and prices up.

When using cap rates to determine transaction pricing, it is important to know the prevailing cap rates in the target market for A and B class assets and to have a sense of the product availability, property condition, and the demand from both local and foreign investors.  Prevailing cap rates are published quarterly for primary and secondary markets for all commercial real estate asset types by the leading national and international brokerages.  In closing, it is crucial when using cap rates to ascertain transaction value that buildings used to determine cap rates are truly comparable, i.e., similar unit size, lot size, location, suite mix, leases maturity, building condition, and so forth.  It is also important to determine whether a building’s pro forma includes capital expenditure below or above NOI, since calculating the cap rates with capex above or below NOI will significantly affect property valuation.