Cap Rate Follies By Tony Seruga, Yolanda Seruga And Yolanda Bishop At Isnare.com Ezine Articles

One of the variables most often mismanaged, and flat out misunderstood, in commercial real estate is the capitalization rate. The cap rate is the rate of conversion of income generated by a property into value for the investor. Dividing the revenue a property generates by the cap rate gives a return on capital. Using this, an investor can reasonably assess how much debt servicing needs to be done, and gauges the rate of return. Unfortunately, something that sounds so simple in theory turns into a morass of competing paradigms in practice. What follows is a brief summary of four common cap rate mistakes, and how to avoid them.

The first fallacy is believing that all the data you have, on transactions of similar properties or regional properties, is accurate. Much of this fallacy comes from the fact that even a decade ago, this data was all but impossible to get; now there are several competing sources due to the Internet and comparison of database. The guard against this isn’t complete skepticism, but instead, taking the time to do your own due diligence on income, vacancy rates, expenses, and the like, in addition to using the commercial services. Always check the numbers is a common mantra in investing, and it’s no less true when dealing with cap rates. In particular, be wary of round numbers, and unique terms. If the person providing the information cannot translate it into data that you can verify, it’s not a good sign.

Related to this fallacy is believing that all the sales disclosures are valid. Roughly a dozen states don’t require full disclosure on property sales; even the ones that do have loopholes that can and will be exploited. Once again, doing your homework is critically important here, as even minor variations in the cap rate can have enormous impact on your investment. When in doubt, try to get two independent sources to verify the sales price; the local county sales tax register isn’t a bad place to start, and you should try to independently verify data with the buyer, seller and any financial institution brokering the transaction.

There is also an observer effect; what’s the minimum dollar amount that a data service will report on a sale? Some (but not all) will only report sales above a minimum dollar amount, in the realm of $500,000 or more. In particular, check to see if there are other components included, such as the business value being worked in to boost the price. Comparing sales prices that mix in business value and pure real estate values will give a greatly skewed data set. Similarly, any property that allows the buyer or seller to pocket cash off the record will skew the data.

Related to the observer effect above are the buyer’s expectations. What did the buyer expect from the transaction? Did they expect to renovate the building? Did they buy it solely for the upside potential? What reasons caused the buyer to acquire the property – factors like this will help you weed out comparison properties that had overly inflated (or deflated) prices due to externalized factors, and the concomitant variability in cap rate.

The ultimate answer to all of these cap rate issues is knowing when and how to do your homework. There are more follies to be explored, and we will be covering them in future articles.

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