Why Cap Rates are a Blunt Instrument in Office Building Valuation

Cap rates are not an all-encompassing measure of the true value of commercial real estate. It’s common to lean very heavily on cap rates as an indication of value, but it’s only a broad measure that doesn’t take into account the specific circumstances of the building, its tenant mix, length of lease terms, the in-place rents versus the market rents, and the supply demand factors in the local market.

Feldman Equities has acquired over 11 million square feet worth in excess of $3 billion in office buildings.  Experience has taught us to look far deeper than the headline cap rate to understand the potential value of a building. When we’re trying to establish the value of a building we’re acquiring, we look at many inputs, including marking-to-market every lease in the building.

What Are Capitalization Rates?

The capitalization rate (cap rate for short) of a building is calculated by dividing the total net operating income of a building by its purchase price.  For example, if you acquire a building that cost you a total of $50 million to purchase, and that building will provide you and the investors with a net operating income each year of $5 million, then you would say that building was being purchased at a 10% cap rate. In stocks and bond terms, the building is delivering a 10% yield or a 10x multiple of earnings.

The cap rate is often used to derive the value of a building.  In a market where buildings are trading at, say, a 5% cap rate, the building in the example above would be valued at $100 million because buyers would be looking for opportunities presenting a 5% yield or a 20x multiple on earnings.

The lower the cap rate, the higher the value of a building; the higher the cap rate, the lower the value of a building.

The mistake that novice investors make with office buildings is to look at the cap rate as the most important metric of value without understanding that the valuation is a sum of its parts.

Related:  What Is a Good Cap Rate in Commercial Real Estate?

Not all cap rates are created equally.

For all commercial real estate (CRE), and especially office buildings, the in-place leases contribute a lot to the valuation of the property. Whether those leases are at, below, or above market rates will have a direct impact on the value of the building.

All things being equal, marking to market your in-place leases will either raise or lower the cap rate of the building overall. In-place leases with below market rental rates tend to push cap rates down because it is likely that when these leases expire, ownership will be able to reap substantial revenue increases. Conversely, above market leases will tend to cause the cap rate to be higher because the landlord may actually see his revenues drop when leases expire and roll to market.

Marking a lease to market means taking a critical look at all the terms of an individual lease, and recalibrating its actual value based on market conditions. For example, a long-term lease to a credit tenant will weigh more forcefully on the overall valuation of a building than a short term lease to a non-credit tenant.

Let’s take a closer look at an example to demonstrate this concept. If you look at the valuation of a single-tenant office building with a 10-year lease that expires 1 year from the date of purchase, marking that lease to market will depend on whether the tenant is paying below, above, or at market rents.

If they are paying below market, the cap rate will go down (i.e. the value of the building will go up) with the anticipation of increasing rental income upon the expiration of that lease. Or, if it’s been a tough market that year and they’re paying above market right now, cap rates will increase (i.e. the value of the building will be discounted) because of the higher risk of rental income streams decreasing once a new lease is signed.

When this concept is applied to a 350,000 square foot, multi-tenant building with anything from 30-50 individual leases, you can see that a generalization of the cap rate for the overall building does not reflect that building’s true value.  A careful examination of every single lease is required in order to determine if a building is properly valued – and only a seasoned office building sponsor will be able to determine the building is undervalued or overvalued by its current owner.

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What Else Goes into Valuations?

Valuing a building simply on cap rate doesn’t give you an accurate picture of what you can expect and what kind of risks you could encounter with the investment. Cap rates are not a one-size fits all valuation tool, because they tend to ignore other vital factors, like:

  • Length of Leases

If the in-place leases for a building are all expiring in a short timeframe, that increases the risk of the investment and could impact overall value depending on whether or not the current leases are paying market rates or not. Long-term leases will have less impact on the variability of valuation because they offer greater predictability. IA healthy mix of staggered lease expirations is desirable for risk mitigation by balancing opportunity with predictability.

  • Number of Tenants

Single-tenant leases tend to hold more risk than multi-tenant leases, because of the possible termination of the lease either through expiration or bankruptcy. This risk can be mitigated if they are a strong credit tenant with a key long-term net lease (i.e. a net lease is a lease which provides for the tenant to pay all of the building’s operating expenses).

In general, having a large number of tenants in an office building means there is a lower risk to the landlord.   A large number of smaller to medium size tenants is far preferable to a single tenanted office building. At Feldman, we prefer not to take on tenants who comprise greater than 10 percent of any building’s total rentable square footage.

  • Market Conditions

Current market conditions have a lot to do with valuations, especially when you’re looking to mark leases to market. Is the market tight? Expect lower cap rates. Is the market turning towards hyper new supply? Cap rates may increase. Markets experiencing higher vacancy rates will produce higher cap rates, and vice versa. Whatever the market is doing at the time of sale will impact the purchase price of the property, for better or worse.

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While cap rates can be used effectively in, for example, multi-family investing to paint a picture overall of the value of a building, in an office building investment cap rates have too many inputs to offer a crystal-clear picture of a property’s value. Two buildings may have similar cap rates, but may have arrived there because of drastically different factors and the skill of the operator in calculating those cap rates is the measure of the dividing line between success and failure.

Here at Feldman Equities, and based on our considerable experience owning and operating office buildings for nearly 35 years, we always look past the cap rate to see what else is going on with the property itself, the tenants, and the market at large.

From our experience, when you mark to market an office building, taking all of the above factors into consideration, you end up with a more reasonable valuation of the property and that is one way that we have thrived and survived through good times and through many recessions.

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