When looking at commercial real estate purchases most buyers and sellers will be looking for metrics to evaluate their situation. Two of the most common are cap rates and price per square foot.
Price per square foot (PSF) is NOT a formal valuation method (cost approach, income capitalization and sales comparison) However, PSF is a frequently used method to quickly understand if a building or piece of land is in line with the rest of the market. People find price per square foot easy to understand as it can be simply taking the asking or sold price and dividing it by the square feet of the building. Alternatively, it can be used to compare expenses and revenues or the cost of renovations or new construction. Benchmarks are often used from industry published reports and/or based upon local knowledge and experience. Comparable properties in similar locations have similar PSF metrics. PSF needs to be used in conjunction with other formal valuation metrics.
Cap rates are associated with commercial/industrial properties or residential real estate held for investment. The cap rate is a metric that represents an investor’s expected return on investment assuming an all-cash purchase. Cap rate refers to an application of the capitalization concept, which uses a ratio formula that relates the rate of return on your investment, based upon the income of the property to the purchase price. Cap Rate=Annual Net Operating Income/Market Value (Price)
Annual net operating income is total operating income – total total operating expenses. A property with an annual net income of $100,000 and costs $1000,000 would have a cap rate of 10%. The cap rate can be used in reverse to find the property value. A property with an annual NOI of $60,000 and market cap rates of 6% for comparable properties would have a value of $1000,000.
Cap rates can allow investors to compare the prices of different buildings with the same tenant or near by properties with different tenants. Cap rates are impacted by bond rates, location of a building, creditworthiness of a tenants, the length and terms of leases and the existence of corporate guaranty. Tenants with higher credit quality and longterm leases will drive cap rates lower. A low cap rate is typically good for sellers and a high cap rate is good for buyers. Cap rates rise and decline with interest rates and the overall economy. Strong economic growth and low interest rates result in compressed cap rates.
Cap rates only look at income and value at a specific point in time, namely, time of a sale. They do not measure performance over a lengthy period. It is important to consider other factors that cap rates may not take into accounts. These can include, under market rents, capital investment required, capital investments made, favourable/unfavourable debt, rising or declining rental market or condition of units within a development.
Cap rates are a broad indicator of conditions within a given market and an indicator of future potential. They should not be relied upon as single investment metric but used as part of a broader analysis.
