Investors and property-owners must consider the future earnings of a commercial property to determine a project’s feasibility. As such, brokers who want to help their clients determine whether a project will be profitable should understand the capitalization (“cap”) rate and the internal rate of return (IRR).
Both of these rates help determine a project’s potential value. To help your client determine the cap rate and IRR accurately, you must know what factors go into determining these calculations.
The cap rate is usually derived from three sources:
- Market and/or buyer’s objectives: When the cap rate is derived from the market, there are a host of market issues affecting it. Often, the cap rate may be further adjusted because of intuitive decisions made by the buyer, based on factors such as building and construction class, occupancy levels, property age and condition.
- Published data: Some national appraisal and accounting firms do quarterly surveys to determine cap rates in several metropolitan markets.
- Market survey: The commercial divisions of local real estate companies provide this information.
Cap rate is determined by dividing the net operating income (NOI) of the sale comps by the sale price. The cap rate’s accuracy depends on the accuracy of the other components in the formula.
Risk is an essential component of the cap-rate formula because the lender’s perception of risk has a direct impact on the loan pricing. Risk is determined by two major factors — market risk and property-specific risk.
With market risk, lenders evaluate the property type, stage in the development cycle and the specific metropolitan area.
With property-specific risk, lenders look at these factors:
- Whether the property is single-purpose or special-purpose
- Lease-rollover rate
- Rent and occupancy levels
- Expenses and capital improvements
- Current cash flow
- Value appreciation and income appreciation
In measuring risk and returns, lenders examine how sensitive a specific property’s cash flow is to market-wide fluctuations. They then make a judgment call and price the transaction at a level commensurate with their perceived risk.
The cap rate’s accuracy also depends on the accuracy of the NOI (which is essentially gross operating income minus operating expenses). And because NOI depends on the types of lease used in a property, it is important to understand the types of commercial leases. They are categorized as the following:
- A net lease obligates the tenant to pay utilities, real estate taxes and other special assessments.
- The net-net (NN) lease generally requires the tenant to pay all items included in the net lease plus the insurance premiums agreed upon in the contract.
- The net-net-net (NNN) lease generally requires the tenant to pay all items included in the net and net-net lease, plus all agreed-on items of repair and maintenance. NNN leases are often used for industrial properties and national franchising chains.
- A ground lease, sometimes called a land lease, is a net lease used when the land-owner leases unimproved property to a tenant who constructs on the site. The ground lease must be subordinated to other liens.
- In a gross lease, the landlord pays all costs. An apartment rental is a prime example of a gross lease.
- A modified gross lease is a gross lease that has been modified to include some of the costs common to a net lease.
- A percentage lease, sometimes called an overage lease, is used for retail property. It usually provides for the payment of a fixed base rental fee, plus a percentage of the tenant’s gross income in excess of a predetermined minimum sales amount.
Internal rate of return
The IRR, or yield, is similar to the cape rate, but it is not the same. IRR is the annualized yield on income generated or income capable of being generated within an investment over a period of ownership. The capital that is generated for the IRR is the annual NOI plus the income generated from the property at the end of the holding period. This anticipated value is called the reversionary value and is based on the anticipated cap rate at time of sale, which is called the reversionary cap rate.
The cap-rate calculation only uses the first-year NOI and purchase price, while the IRR calculation uses NOI for multiple years, purchase price and sale proceeds.
Because IRR is based on pro-forma data, its accuracy is not absolute. It does, however, give a reasonably accurate picture of performance. It also gives a good indication of the maximum amount an investor can pay for the property while still receiving desired yield.
The question for the property-owner really is, what is a reasonable IRR on the investment? If an investor can put money into low or no risk securities at 6.5 percent, what rate would be required for risk-based real estate investments? This required yield determines investment value in the investor’s eyes, and it varies between property types.
Presumably, if the professional requires an 8.9-percent IRR, a less-sophisticated private investor without access to published data would require a higher return. Traditionally, noninstitutional-grade investment IRRs run about 2 percent above institutional-grade investments. This higher yield would be necessary to compensate for the risk inherent in a smaller project where future value may be speculative.
If the IRR of an investment is more than the cost to borrow, the investment has positive leverage. In other words, the debt portion of the investment is generating revenue beyond the cost of the debt. If the IRR is less than the cost of debt, the investment has negative leverage.
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In commercial real estate, cap rate is the preferred measurement of value. Cap rate is used to calculate return on investment dollars, value or net income, whereas IRR tells the investor potential yield over the holding period.