If you see a commercial investment property for sale and the description includes a CAP (Capitalization Rate), what does that mean? A CAP rate describes the net annual income stream of a property based on a “snapshot” of time usually the current year. An easy way to think about a CAP rate is that it answers the question “what would I pay for this property today for the right to receive this income stream?”.
To analyze whether the price is worth the potential income you need to analyze the income to see how stable or risky it is. So, what are the risks? What are the chances that the income stream that you were counting on doesn’t materialize? Perhaps it isn’t always the tenant ‘s business situation but a sudden economic downturn due to a natural disaster, a subprime mortgage meltdown or worldwide pandemic. Many buyers of vacation rentals in Hawaii were hit hard when their income stream disappeared in an instant but the mortgage payments and taxes did not. Several months of no income translated into a significant bump in the number of vacation rentals put on the market this summer. Thankfully, due to Hawaii’s isolation, we were able to be the place everyone wanted to go to ride out the pandemic. The residential real estate market barely saw a hiccup and is again seeing a solid sales record.
On the commercial real estate side, if the property you were looking at had tenants whose businesses were tourism related, you would see that the Net Operating Income shriveled up. If the property had tenants whose businesses were construction or essential food related, you may have seen it hold steady albeit with some nervousness. Healthcare tenants thrived and new businesses have sprung up in properties that were able to accommodate medical related tenants.
What are the Tenant-related risks. How likely is it that the tenant(s) will continue to pay this rent? Is the tenant a new unproven business? Is the tenant a large national chain who guarantees the lease? As we have recently seen on Maui, the size of business doesn’t necessarily mean they are a good bet. In recent years we have seen Pier One, JC Penney, Kmart and Hertz sink into bankruptcy. The pandemic also hit 24 Hour Fitness who closed virtually overnight when gyms where shut down.
Another element of risk would be the remaining term on the tenant’s lease. If half the tenant’s leases are up within a year or two, how likely is it they will renew? If something happened to that tenant, would you be able to replace them with another tenant who will pay the same rent? If you were looking at the income for Maui Marketplace a few years ago, you would want to know that one of its anchor tenants, Lowes, was building a new store and would soon be gone.
Perhaps the riskiest element of property income is percentage rents. Many retail properties generate significant portions of their income from Percentage Rents. This rent is rent that is paid on gross sales over a set breakpoint. A tenant would pay a basic rent and then, if they reach a certain point in their sales, they pay an additional amount. This percentage rent is a way for a landlord to be compensated for having a property that is above average in gross sales per square foot either because of an exceptional location or because their leasing team was successful in creating created by a great tenant mix that attract tenants who bring in customers who will also shop at the other stores in the center. On Maui, centers that have a proven record of accomplishing this would be the Shops at Wailea and Whaler’s Village. A risk that is associated with percentage rents is that if an anchor tenant is lost, would the center still be able to generate the same sales for the other tenants? I could go on but this might be a subject for a future post.
While it may seem counterintuitive, a higher cap rate means a lower price. A higher cap rate can indicate the property has a high vacancy rate, deferred maintenance or a lousy location. Whereas a lower CAP rate generally means that the income stream is strong and likely to continue. Theoretically, a buyer would be willing to pay more for a property with a strong income.
In summary, a cap rate allows a “quick look” at a property’s income and asking price to give a buyer some insight into whether the investment is attractive to them.
In Part two we will look at the formula to calculate a capitalization rate and how to find an appropriate rate for your property.