TelferYoung Limited
Don't Take Cap Rates At Face Value!
11 June 2008
All those involved in the property sector at some time or another, have been exposed to so-called 'facts' on major property sales. We all hear of capitalisation rates quoted for sales but what information do these 'quoted' figures give us?
The analysis of a direct capitalisation (CAP) rate from a property sale is an essential tool for establishing value. Accurate and reasoned analysis is essential to arrive at the cap rate from a property, but in many cases the significant factors affecting it are either ignored or simply overlooked.
When a property is sold the resultant capitalisation rate from the property is analysed and then can be used for comparative purposes. There are many pitfalls in the analysis of a capitalisation rate from a sale and in many cases we do not know what the quoted cap rate relates to. Was it analysed from the sale based on the rental return from the property, or was it based on the true net cashflow after allowing for management and vacancy factors? Was it based on market rents or existing, perhaps dated rentals? Are the leases true net leases? Is a rent review imminent?
Before progressing further, it is important to reflect on the simple maths used in the capitalisation method of valuation. One of the investment approaches to the valuation of income producing properties uses the capitalisation of income streams to arrive at the value of the property. The direct capitalisation theory of valuation is expressed by the equation:
V= I/R (with V = value, I = income, and R = return or CAP rate)
Using this formula the capitalisation rate or return from property sales can be easily analysed by re-arranging the formula as follows:-
R = I/V (with R = return or CAP rate, I = income, and V = value)
Once a reasonable sample of sales of income producing properties has been analysed a range of CAP rates can be established. These rates can be used for valuing similar investment properties. The difficulty in using the capitalisation approach to valuation is obtaining reliable information in relation to the price. As shown above there are two variables in arriving at the cap rate; the sale price and the income. Sale prices are generally readily available although sales information however does not always reveal other factors which may have a material effect on the price. These include vendor finance, share or property swaps, low interest loans, etc.
Obtaining the rent from the property is somewhat more difficult. In most cases the leases on the properties are not registered on the title so rentals cannot be obtained from this avenue. The property professional is therefore required to contact the vendor, purchaser or lessee in an attempt to obtain accurate information.
In order to establish the capitalisation rate from a sale we are required to verify the rent. To establish whether it is market based we compare the rent with market rents for known similar properties.
Further analysis may be required to arrive at a net rental from the property after deducting possible outgoings borne by a Landlord including items such as management, vacancies or non-recoverable expenses. Once this analysis has been completed the property professional is then in a position to establish the true net market rent.
Quite obviously the actual capitalisation rate on the property is important to a potential purchaser and this has to be based on accurate information. TelferYoung has the resources, the experience and the expertise to accurately analyse sales and rental evidence to obtain an accurate market value of any type of real estate property where price is influenced by the income producing capacity of the asset.
A very simplistic analysis of a sale price based on the quoted rental return is extremely dangerous and, in many cases, is of little assistance to the property professional. Considerable analysis of each and every sale is required to achieve a range of market yields for any one category of investment property. In many cases valuers have only one or two comparable sales available and seldom do the lease terms or review dates coincide to provide a uniform basis of analysis. This is where the skills of your TelferYoung professional come into play and it is essential that all relevant factors relating to the sale are obtained before the capitalisation rate can be analysed with confidence.
John Ryan
This monthly paper reflects the views of the writer and may not represent the views of all TelferYoung staff.