Properly assessing a commercial investment property’s value is a complex and lengthy activity.
Due to the time-consuming nature of the process, the temptation is to simply apply the prevailing cap rate in the market to the potential net operating income. The problem with this basic calculation is that it undermines a few fundamental assumptions in the Yield Approach to Value.
First, the approach implicitly assumes that the income is sustainable in perpetuity, meaning that the current level of income will remain as it is for the foreseeable future. This assumption is based on the sound mathematical principle that all of the future income is ultimately discounted to a present value. If the property has expected vacancy forthcoming, it is reasonable to expect that the income will be unstable. While one might argue that a property can be leased at market rates, the simplified yield calculation does not inherently include the loss of revenue through the down time or the costs involved in securing a new tenancy (such as tenant improvements, inducements, commissions).
This leads into the second issue, which is neglecting to recognize an allowance for any potential credit loss or vacancy. Aside from a building leased entirely to Triple A tenants, virtually every building will have an expense of this nature by way of a current lease expiring or through the unpredictability of short-term tenants in general. It is reasonable to suggest that even a Triple A tenant may be prone to default. The net operating income should account for this expense before it is ultimately capitalized into an expression of value.
The third mistake occurs when the net operating income is not a true reflection of what income is actually remaining after all property expenses have been paid. A considerable amount of confusion lies in this area as the terminology often has different meanings for different investors. Leases might be referred to as single net, double net, triple net, net net, fully net, absolute net and even modified net.
Regardless of what it is called, it is imperative the income that is ultimately capitalized is completely net of all expenses in addition to a vacancy and credit loss allowance.
The last consideration is to ensure the subject property is being compared to other similar properties. If the prevailing cap rates for a particular asset class show a hypothetical range between 6.5 per cent and 8.5 per cent, more thorough analysis will be required to determine what rate should be applied to the subject property. Using an arbitrary number of $250,000 in net operating income, the range just discussed would produce a rounded estimate of value between $2,940,000 and $3,846,000. Using a low cap rate, which may be intended to represent regional shopping centres, and applying it to a small community retail plaza will considerably distort an estimated property value.
There are limitations to the approach as it does not take into account financing or tax considerations. Accordingly, many investors might endeavour to construct more detailed calculations, either by way of a Normalized Net Operating Income or through Discounted Cash Flow Analysis. However, that is not to discount the value of the Yield Approach. The term “cap rate” is fairly ubiquitous in commercial real estate and is often discussed by investors, appraisers, bankers and agents. Calculating the value via a cap rate is typically the starting point for virtually every investor, and this extends to include the largest institutional pension funds and REITS. Although incorporating cap rates is a very valuable tool, it does run the risk of being misleading and unreliable if it is done incorrectly.
The selected cap rate needs to be commensurate with similar properties, the income that is capitalized should be clear of all expenses and net of a vacancy and credit loss allowance, and the income should have stability into the future. It is pertinent to emphasize that the Yield Approach to Value is only capable of computing a reliable indication of value if all of these factors are accounted for.
REM Magazine Dec 13, 2012 By Chad Griffiths
Chad Griffiths has completed more than 200 commercial transactions, ranging from 1,000 sq. ft. to 80,000 sq. ft. He holds the CCIM designation, awarded to brokers who have completed an advanced curriculum and demonstrated a high level of commercial real estate experience. He is an associate broker at NAI Commercial Real Estate in Edmonton. (780) 436-7410.