Photo by Tima Miroshnichenko from Pexels
The only time that a lender , or appraiser , would use the lower rents is when those rates were locked into a longterm lease or a rentcontrolled property . I underwrote the following example : A prospective loan for an industrial building in Richmond , California . The property was leased fee , leased out to a third party for 99 years , with 50 years remaining . The lockedin rent was only 18 cents per square foot triple net . The property owner and broker argued belligerently that current value should be based upon today ’ s rents .
An inconvenient fact in this example is that the property owner is locked into an 18 cent per square foot monthly income stream for the next 50 years . Capitalized rents will be based upon 18 cents per square foot lease rate . The capitalized value with an 18 cents per square foot will have a dramatically lower NOI compared to a similar building next door that rents at $ 1.75 per square foot lease rate monthly .
A historic rents comparison databases are available to determine market rents to calculate a correct capitalized valuation . Historic market Cap Rates may vary , even in the exact geographic location , depending upon the building improvements , effective age , class of construction , offstreet parking , furnished or unfurnished , condition , compliance with zoning , easements or lack of needed easements , and amenities . Examples include ClassA vs . ClassC office , industrial , apartments , older dated , economically obsolete and under parked compared to a new modern building with adequate parking and currently popular amenities .
Advantages and disadvantages of the Capitalization approach to value :
Advantages :
1 . This method converts an income stream into an estimate of the value of the incomeproducing real estate .
2 . The method is a common standard in the appraisal , lending , and development business .
3 . While the income capitalization approach is common in evaluating commercial incomegenerating properties , it can theoretically be applied to any income stream , including businesses .
4 . Commercial appraisers are a reliable source for determining market Cap Rates .
5 . Commercial Realtors ® provide an excellent source of cap rates with websites such as Costar and Crexi
6 . There are online databases such as the CBRE / USCapRateSurveySpecial Report2020 to obtain reliable data .
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Disadvantages :
1 . The method is used for “ comparison only with similar properties in a close geographic area .” The method does not consider liens on the property and debt service . A Cap Rate calculation is done as though the property is debt free . Cap Rates cannot be used to calculate overall net cash flow or cashoncash yield when a loan attached to the property ( Income , less operating expenses , less debt service ).
2 . The results of a Cap Rate calculation are specific only to a similar area with similar properties in certain segments of the market . You could not use Newport Beach , California cap rates to compare with a similar building with similar usage in Riverside , California . Also , the demand for properties and Cap Rates for different segments of the real estate market change . Current examples are residential income properties and Industrial are and will continue to be in demand . I read one estimate that industrial in the U . S . will require an extra billion square feet of warehouse by 2025 . Office and lodging / resort related properties , not so well . Patterns change !
3 . The method contemplates stable economic market conditions . If a market experiences a significant downturn , collapses , or is subject to extreme political uncertainty , the calculations using market cap rates may be rendered irrelevant .
Historic market Cap rates may vary , even in the exact geographic location , depending upon the building improvements , effective age , class of construction , offstreet parking , furnished or unfurnished , condition , compliance with zoning , easements or lack of needed easements , and amenities .