RE Report/Analysis
As the commercial real estate market becomes softer and more susceptible to the deep recession, Cap Rates or Capitalization Rates, are going to become an even greater concern and metric to investors.
Cap rates vary depending on the supply and demand for commercial property, capital credit markets as well as the overall economic climate.
Over the previous few years, Cap rates were too low due to an assumption of continued economic growth and rising rents. This partially contributed to an over valuation of most commercial properties.
The Cap Rates of the past few years never truly reflected the true potential risk factors involved with commercial property and the ebb and flow nature of economics. Investors must consider Market risk, Interest Rate risk and Operational risk.
Consequently commercial mortgages may be in-line to take huge hits because of the fluctuating cap rates investment banks use to value commercial real estate.
Matthew Anderson at Foresight Analytics, calculates that cap rates have risen to at least 8%, based on such recent property sales and the decline in shares of REIT’s. Prior, the average was 6% at the top of the market. Today’s Cap Rates are a bit higher, but probably not accuratley reflective of the current risk.
A change in cap rates combined with an approximate drop of 15% in property cash flows, means commercial property values overall might have fallen more than 30%. Moody’s and Case-Shiller indices’s reflect approximately a 20%+ figure.
Cap rates tend to utilize one year of Net Operating Income to determine the value of a property. This is somewhat a rough, or quick and dirty indicator of value. Traditionally, property value increase as NOI (with lease escalation clauses) increases as well.
Also, most Cap Rates do not take Opportunity Cost into consideration. I.E.- The best alternative to a specific investment, the most valued alternative passed up, is the opportunity cost of a specific investment decision.
Utilizing realistic Cap Rates are critical to determining a property’s true value potential. Finding a ‘real’ cap rate can be akin to finding a needle in a haystack.
A more reliable indicator of value using the Income Approach, is to perform a Yield Capitalization analysis rather than a Direct Cap analysis. But one of the draw backs in this type of progressive analysis is that forecasting Cap Rates becomes more of a guess than an exact science.
A good property valuation analyst will source many different data sets as well as analyze the statistics on the property in question to come up with a credible cap rate. Though often times, obtaining true data from a property owner can prove to be difficult.
Strictly relying on the word of the owner or manager, and top name cap rate survey companies can lead to unrealistic figures in the analysis and value potential. In the end, it becomes an issue of inturpeting and balancing all the varying data into a reliable analysis.