Standardizing Cap Rate Calculation… Changing the Commercial Real Estate Industry

Cap rates are the ratio between net operating income (NOI) of a commercial real estate asset and its capital cost or market value. Cap rate calculation you would think would be a very standardize process across the board as it is the way to value a commercial real estate asset, however it is just not the case. From one broker to the next cap rate calculations could range by over 100bps. This difference makes it extremely difficult for investors to compare two like kind or even two exact same properties in order to best decide which one may work best for their portfolio. The industry needs to change. In order to all be on the same page when it comes to valuing an asset, there needs to be standardization of cap rates.

Now we all know cap rates will change based upon asset type, location, tenant, term etc. but there needs to be a formula that all brokers must stick to if the investors are going to compare two properties based on cap rates. It is like buying a car but having the same car be priced in two different ways based on how the car salesman sees fit. We, as real estate brokers, need to understand that yes, we want the properties we represent to be shown in the best light, but there are just certain factors that always need to be accounted for when valuing a property. This will help not only investors, but also the industry as a whole, to become a more “honest” version of itself. Gone will be the days where you read an offering memorandum for an 8% cap deal but the valuation has failed to include management reserve, vacancy, capital reserves etc. (this valuation would be for a retail center for example). The broker’s typical response to leaving these items out of their underwriting is, “this center has never been vacant, or the owner manages it himself.” That is all well and good, but when the buyer goes to get a mortgage on that retail center the banks will, without a doubt, add in these reserves in turn bringing down the “true” net operating income on the asset which therefore brings down that 8% cap deal to about 50bps less, around 7.25-7.5% with all reserves included. Now, you are starting your negotiation at a huge disadvantage. This system needs to change and industry professionals need to step up and start valuing deals in a fair and even way to allow the true market valuations be represented on assets that are on the market.