Commercial Real Estate Capitalization Rate - Investor Required Return
The basic formula is IRV or Income/Rate = Value. Specifically, NOI or Net Operating Income/Capitalization Rate of Return = Overall Real Estate Value.
The Overall Capitalization Rate of Return: Encompasses or Takes into Account, Any & All Risk vs. Return in a Real Estate Investment Sale or Purchase for Investor Buyers & Sellers of Income Producing Properties.
Non Market Level Concessions that Required Substantial, Upward vs. Downward Adjustments or Deductions vs. Additions in the Final Sale Price for 100% Tenant Occupied, Actual Capitalization Rate Sale Comparables - Created a Huge Up or Down Swing in the Final Capitalization Rate of Return:
1. $100,000 sports car Included in the Sale Price Consideration
2. 13% Lower than FMV - Fair Market Value Sale Price since Seller was Motivated & Needed to Sell before year end to move out of state
3. $10/SF of Building Deferred Maintenance for Unbuilt Offices that Still Needed Build Out Improvement Work to be functional
Major, Primary Build Up Factors that go into the Overall Cap Rate for a Subject Property that Increases or Decreases Rates of Returns & Property Values:
Below vs. Above Market, Discounted vs. Premium Concessions or Terms, some examples:
A. Distressed Motivation of Seller or Buyer in the Sale or Purchase Price: REO - Real Estate Owned by the Lender or Mortgage Note Holder vs. Short Sale vs. Seller Had to Sell to Move out of State by Year End - a Must Sell vs. 1031 Tax Deferred Upleg Exchange - a Must Purchase situation.
B. Deferred Maintenance - Property Still Required TI’s - Tenant Improvements: Sale Price Credits Due to Needed Improvement Work to Get the property Back to Commensurate Building Quality & Condition of Improvement levels that is Market Standard for Competitive, Comparable Properties - Roof is older and needs replacement, Parking Lot reslurry - poor maintenance, HVAC - Heating, Ventilation & Air Conditioning, Office Carpet/Paint/Reconfiguring - current Warm Vanilla Shell Condition vs. Move In Ready, Plug & Play.
C. Location: General vs. Specific - Signalized Corner vs. Mid Block
D. Building Types & Uses: General vs. Specific - General Retail vs. Fully Built Out Sit Down Restaurant
E. Actual Occupancy of Property: Should be Compared Only with 100% Occupancy Tenants in place or Occupancy Levels Need to be at Market Level Standards
F. Property Type or Tenant Uses: General vs. Specific - General Office vs. Highly Improved or Specialized Creative Office
G. Site Coverage Ratio, FAR - Floor Area Ratio & Parking Spaces: Excess Land vs. Lack of Parking Spots
H. Age/Quality & Condition of Improvements
Market Level Base Rent, Maximally Acheivable Rental Income Obtainable from Tenants: Pro Forma - Fee Simple at 100% Occupancy or Potential Gross Income at its Highest & Best Use(s) - Is Existing Contract Rent in Place Paid - Below vs. At vs. Above Market:
a. Credit Worthiness of Tenants: Local vs. Regional vs. National
b. Length of Tenant Leases: Monthly vs. Mid vs. Long Term
c. Financing: All Cash vs. CTNL - Cash to New Loan Debt
d. Total Rent - Base Rent + Landlord Pass Thru's of Operating Expenses: Base Rent in Addition to Additional Expense Pass Thru's to Tenants. Property Expense basis of FSG - Full Service Gross, Modified Gross or NNN + Additional Expense Pass Thru's or NNN's or CAM's - Common Area Maintenance Expenses.
e. Secondary Component: Annual Base Rent Increases.
Very Important to Note Rents & Values for All Property Types are Always Changing/Variable & Not Constant: the Real Estate Market (Commercial - Retail, Office, Medical, Multifamily Apartments - 5 units or more & Vacant Land, Industrial - Warehouse, Distribution, Flex/R & D - Research & Development, Manufacturing and Residential - SFR to 4 units) is dynamic & in flux, Only a Temporary Snapshot as of the Date of Value - Retrospective or Current. Can Dramatically Change Over Even a Short Period of Time and have a Major Impact on Real Time, Overall Sale Price or Property Value.
All Build Up Items for Actual Not Pro Forma Capitalization Rates Need to be at Market Levels: Competive, Truly Comparable Properties in the same Submarket location to compare & contrast with: Base Rent for Just Leased, Lease Comparables, Vacancy Rates & Collection Loss, Property Operating Expenses - the Largest Component is Property Taxes, Actual, Recently Sold Capitalization Rate Sale Comparables & Successfully Sold, Closed Sale Comparables.
Sale Comparables Transactions, Must be apples to apples, Similar Buyer Motivation - Straight Investment vs Partial vs. Full Owner User.
In Los Angeles County & 5 other Counties - Orange, San Bernardino, Riverside, Ventura & San Diego/Southern California, typically, there is a +10% to +20% Real Property Value Differential or Sale Price Premium for Commercial Properties. For Industrial Real Estate, there is an Even Higher Spread, typically, +20% to +40% Sale Price Premium.
Every Real Estate Submarket for each Individual Subject Property is Extremely Unique with Different Income Producing Capability and Locational Differences - Even Right Next Door to or Across the Street due to many physical characteristic nuances.
For Commercial Real Estate Investments, there is a lot that goes into a Cap Rate. Property Investors, looking to Sell or Buy Real Property should first Analyze and Research Lease & Sale Comparables on a Fee Simple basis analysis - Pro Forma, As if the Subject Property was 100% vacant and Leased at Market Levels at its Highest & Best use(s) for the Single or Multi-Tenant Subject Property. This is the Maximum Potential Gross Income or Maximum Value obtainable, as a Best Case scenario.
Differences also exist in Individual Property’s, Specific Uses - Studios vs. 1 Beds & Unit Sizes - Due to Economies of Scale, Smaller Units/Suites will typically Achieve Higher Rents vs. Larger spaces. Careful consideration is required to be Accurate & Realistic in order to Maximum Highest Value or Worth of the Real Estate and nail value down.
Fee Simple number crunching is undertaken to Ensure that a Seller or Buyer of Real Property is Not Overpaying or Underselling, the Maximum Achievable Rents or ceiling - Potential Gross Income or Income Producing Capability will equate to the Highest Overall Commercial Real Estate Property Value or Price at the End of the Day.
All other Market Level build up Property Rental Income & Operating Expense components also need to be Recent & Actual - Not Highly Inflated, Asking For Lease or Sale which Still Needs Substantial Discounting & Negotiation. Just Leased Real Estate Rent Comparable data, truly mirrors what is currently being paid by tenants for space.
With the Most Recent and Actual Recently Transacted Detailed Data, all necessary inputs will be Very Likely - Not Maybe or vague. Very Accurate: Rental Income, Property Expenses & Items Must be Market Derived: Maximum Achievable Rent for specific units/suites uses, Vacancy Rate & Collection Loss, Property Expenses - Property Taxes, Insurance, Utilities, Repairs & Maintenance, Property Management & Replacement Reserves for Capital Improvements to derive NOI or Net Operating Income for clear, confident understanding - Internal Underwriting, Asset Monitoring & Decision Making.
The last step is to compile Actual Recently Sold, Sale Comparables to see what other Investors are Currently Obtaining in terms of a Rate of Return and Sale Prices paid for other Similar Property types just transacted in the area.
Due to the extreme Difficulty in Gathering/Obtaining Confidential & Personal, Detailed fresh data, good idea to obtain a Customized/Tailor Made, Real Estate Evaluation Report or Real Estate Appraisal and retain a professional, knowledgeable Local Submarket Expert, a Commercial Real Estate Appraiser or Real Estate Consultant to get an unbiased, neutral, 3rd party that is reliable, credible and provides added value.
To have even more confidence & peace of mind, additional numerous Opinion Surveys of Market Participants to gel the data to support is also highly recommended so that all items are well supported and not artificially swayed low or high and as a check and balance that everything is reasonable.