How does cap rate change between class A, B, and C properties?
First Central Tower
Cap rates will typically vary depending on whether you’re purchasing a Class A, B, or C property.
There is no one specific definition of what classifies a property as Class A, B, or C. But generally speaking, Class A office buildings are considered to be of the highest quality, in the best location, and/or in the newest condition (whether recently built or recently renovated). Class C properties are typically older, in less desirable locations, and may need extensive renovation. Class B properties are somewhere between Class A and C.
There can be different combinations of these scenarios where, for example, a lower quality property may be located in a highly desirable area, or where a property is in new condition but is in a less desirable condition. In any event, the “class” of a property will have some bearing on its cap rate. Typically Class A properties have lower cap rates than Class B or Class C properties.
What is a good cap rate for Class A buildings
Morgan Stanley Tower
Determining a “good” cap rate for Class A office buildings is rather subjective. It depends largely on your local market. For example, a 5% cap rate may be the norm in high-demand areas such as in and around large metropolitan areas and high-cost areas like Manhattan or San Francisco.
The cap rate for Class A office buildings also depends on which asset class you’re considering. Class A office buildings, for instance, often have higher cap rates than Class A multifamily buildings – but again, it depends on the market.
Finally, a “good” cap rate for a Class A office building in a Tier I market (e.g., Boston, San Jose or Washington D.C.) will look different than a “good” cap rate for a Class A office building in a Tier II (e.g., Austin, Philadelphia and Miami) or Tier III market (e.g., Indianapolis and Kansas City). Buildings that are located in Tier I markets tend to have lower cap rates compared to Tier II or Tier III markets.
By way of example: a good cap rate for a Class A office building in each of the three market tiers might look something like this:
Tier I market: 4.00 – 5.25% cap rate
Tier II market: 5.50 – 6.75% cap rate
Tier III market: 7.25 – 8.50% cap rate
However, as stated earlier, an experienced office building operator understands that there is little correlation between the overall cap rate of a building and the actual value of that building. It is a mistake novice investors often make.
In a multi-tenanted building, each lease has to be viewed on its own merit and assigned a specific value that is a measure of the relationship between the creditworthiness of the tenant, and the length of the lease term. Only an aggregation of these disparate metrics can provide insight into the true value of a building and only sophisticated, seasoned operators know how to accurately assess these variances.
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What is a good cap rate for Class B buildings?
All of the points referenced above apply to Class B office buildings, as well. For instance, determining what is a “good” cap rate for Class B buildings will largely depend on the asset class and location of the commercial property.
Cap rates can also vary within the same metro area. For instance, the cap rate for a stabilized Class B office building in downtown Tampa typically ranges from 6.75% to 7.50%. The cap rate for a Class B office building in suburban Tampa is generally a bit higher, ranging from 7.00% to 8.00%.
Keep in mind that a Class A building can very quickly become a Class B building if proper upgrades and improvements are not continually applied. A Class A building, for example, can be relegated to Class B status if a brand-new commercial project with all the bells and whistles – higher ceiling heights, floor to ceiling glass, fitness centers and other amenities, etc. – is constructed in the same sub-market. The local brokerage community will see the new building as superior, assign higher values to the leases which in turn drives cap rates lower, and the previous A-class building, now a B-class building can suddenly find it losing value overnight as it’s cap rate increases and its valuation falls.
What is a good cap rate for Class C buildings?
When evaluating cap rates for Class C buildings, there is generally one additional consideration: most class C office buildings attract a lower credit quality of tenants. For example, an older single-story office building located in the suburbs may be the home to several “mom-and-pop” business. These buildings tend to trade at lower cap rates because it is more expensive to obtain mortgage money from a lender that is skeptical about the creditworthiness of the tenant base.
Class C properties present an opportunity if they are well located. Sometimes this opportunity is referred to as a “value add” acquisition. A value-add commercial property refers to a building that typically has a lower occupancy and is in need of renovation. Value-add properties typically can be purchased at a higher cap rate than stabilized buildings. At Feldman Equities, we have purchased class B and class C properties in great locations; following renovations of these commercial projects, we have succeeded in upgrading the quality of the tenants.
As was the case for Class B properties, a good cap rate for Class C office buildings will be marginally lower for downtown office properties vs. suburban office properties in any given metro area.
Overall, the higher up the Class scale an investor is willing to climb, the lower the cap rates and the higher the pricing. At the very top are Class A, core assets where there is little expectation of capital appreciation and investors are driven by a low risk yield play. At the other end of the spectrum is the value-add Class-C building that will attract tenants with low or no credit, in poor condition requiring continual maintenance, that experience continual turnover of tenants, and that are not well located. Cap rates may be higher in such circumstances, but as an owner risk is higher and maintaining income levels requires constant attention.
Related: How Influencer Marketing Saved a 40-property Manhattan Office Skyscraper
What impacts a cap rate?
Castille at Carillon
There are several factors that can impact a cap rate for a commercial project, including the current market condition, current in-place rents vs. market rents, lease lengths and expiration dates, the location of the property, and the condition of the property. We take a look at these five factors in more detail below.
Current Market Condition
The state of the real estate market has a major impact on cap rates. In a tight market, commercial property values tend to increase and therefore, cap rates decline. Conversely, in a down market, prices become more depressed and as a result, cap rates increase. An investor may be willing to buy a property at a lower cap rate in a bull market but will invariably look for higher cap rates in a bear market. Knowing where we are in any given market cycle is critical for investors to understand.
In-Place Rents vs. Market Rents
Cap rates are based upon a property’s existing cash flow. Therefore, if rents are below market rate, an investor has the expectation that his cash flow could jump significantly once the leases in place expire and he’s able to capture the higher market rental rate. In this case, the investor is willing to pay a lower cap rate (i.e. higher price) compared to the same property with in-place leases at market rents.
A savvy operator will look for leases that are significantly below market rate, where they can be gradually increased over a period of time (say, over a one- to five-year holding period) through annual increments to bring them to market levels.
Lease Lengths and Expiration Dates
Lease lengths and expiration dates have a major impact on cap rates.
Lease expirations increase risk, and depending on how great that risk is, can have a depressing effect on the cap rate applied to any individual tenant – meaning it causes the cap rates to rise and the value of that lease to go down with the resulting pro-rata impact on overall building value.
Lease expirations for commercial projects substantially add to risk in a single-tenant situation. Single-tenant properties are like a house of cards – the sheer size of that one tenant can have a huge negative impact on the value of the property if that tenant moves out or goes bankrupt. Leasing to multiple tenants, using staggered lease lengths and expiration dates, is a good way to hedge against this risk. In the event that a building is leased to a single tenant with a very near lease expiration date, the cap rate is often very high.
If a tenant has a very long-term lease at below-market rent, this inhibits an investor’s ability to raise rents and improve the cap rate. For instance, if a tenant has 25 years remaining on their below-market lease, it doesn’t matter than a property has the potential to turn a higher cap rate because you’ll have lost more than two decades of revenue in the process.
Location of the Property
As indicated above, the location of a property has a major bearing on its cap rate. Generally speaking, the better the location, the lower the cap rate and vice versa. This ultimately comes down to perceived risk. Well-located properties tend to hold their value better than those in secondary or tertiary markets, and therefore, investors feel these properties are less risky. Many investors will be willing to take a 5% lower return for a property located in a Tier I market compared to the same type of asset in a Tier II or Tier III market.
Location within the market also influences cap rates. Just as home prices tend to be higher in downtown areas, commercial properties tend to be more expensive in downtown areas compared to suburban or rural areas. Investors are typically willing to pay more for office buildings in central business districts, which translates into lower cap rates.
Condition of the Property
The condition of an asset is the fifth factor to impact cap rates. Properties in better physical condition, particularly those with several in-demand amenities, will usually trade for lower cap rates than properties in need of repair.
As such, one of the first things an investor should do when evaluating whether to purchase an office building, for example, is to look at the bricks and mortar of the structure: if the commercial project has the right bones, if it’s well built and the space lays out well, if there are good views (especially of the water), then a savvy investor will be able to lease the property – regardless of the cap rate. And if you can lease a property, you can drive the cap rates over time.
Cap rates are a highly valuable tool for investors looking to understand how a commercial property might perform relative to other assets. That said, they are often misused as a blunt instrument to calculate building value by inexperienced operators. Looking at individual leases and tenant profiles, though a more laborious process, is far more important in establishing true value and potential of a building.
As noted above, a property’s going-in cap rate might be a victim of below-market rents or poor management. That same property may have the potential to generate much higher returns, and therefore, be worth more under different circumstances. An investor should look at both going-in cap rates as well as future cap rates after property improvements are made, as well as the individual characteristics of each tenant, their creditworthiness, the length of their lease and other factors.
Investors should be looking at an investment from all angles, and using the cap rate formula can be a hazardous to your financial health in large scale, multi-tenanted downtown office buildings. Partnering with a seasoned operator who knows what to look for, who is not overwhelmed by headline numbers like the cap rate, and who understands how to uncover value hidden from other is the key to success.
Related: An Introduction to Office Building Investing
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