does a cap rate determine property value or does property value determine a cap rate?

In Market Conditions - Asked by John P. - Mar 21, 2013
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Robert M.
Property/Asset Manager
Exeter, NH

Cap rate is a shorthand, one-year way for measuring investor returns. Actual market sales of properties indicate what cap rates are acceptable to buyers & sellers, as in a property with $100k net operating income selling for $1,000,000, a 10 cap. Often sales are priced on the next year's net operating income. Investors might turn around and try to achieve returns that come close to other recent sales. Of course, buyers want better returns on lower prices or higher cap rates, while sellers want better returns on higher prices or lower cap rates. Since every property, location, buyer & seller are different, and real estate is not a uniform commodity, cap rates can vary quite a bit. Competition for investments among investors lowers cap rates, too. Best to think of it as a past record, and not as an absolute predictor of value.

Mar 21, 2013
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Linda A.
Scottsdale, AZ

Cap rate is the simplest way of determingin the sale price of a property. The income/ occupancy of a property determines the cap rate and the cap rate determines the value of the property depending on supply and demand and market conditions

Mar 21, 2013
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Ron S.
Manitou Springs, CO

After 40 years in the apartment business and more than 120 personal closings, one thing stands out: I’ve seen more investors lose money by using the cap rate method to value property than any other method – other than using a gross rent multiplier.
The cap rate is merely a “snapshot” of how a property is doing at that one point in time or, worse, how it has done in the past. It’s just a step above GRM.
Since the cap rate is a function of net operating income, it doesn’t consider the debt service, principal reduction, future vacancies/rents/expenses and future sales proceeds. Since almost all deals have loans, this reason alone is enough to do further analysis. The main weakness is that it doesn’t consider what the future market holds for the property. We also know that the sales proceeds usually are the largest of the cash flows produced by the property, so not looking at this cash flow doesn’t make any sense.
Prefer Net Present Value to determine value today and IRR for your yield.
Ron Spraggins, CCIM
Founder/CEO of Commonwealth
Colorado's Oldest Apartment Firm

Mar 21, 2013
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Eric K.
Northville, MI

Both are important, and like any good algebraic equation, they are related. Cap rate value (i.e. RANGES) for an INCOME STREAM is dictated by the retailer, their credit, the term, and the strength/escalations of the subject lease. Property POSITION and local market values on land and building should be considered as the guide-post to the long term lower and upper value limits of the property. For instance, the market value of property will change greatly throughout a 20-year initial lease term, but an outparcel of a core project in a high density market with growing incomes is likely to remain dominant.

Mar 21, 2013
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Bruce S.
Pasadena, CA

CAP Rates vary by market. Generally any property in a given market will carry a similar CAP to recent sales of similar property type within that same market (assuming they are reported correctly). Think of it as a triangle with CAP, Price and NOI at each corner. Any 2 of those numbers will determine the other. With a calculated NOI you can determine value based on a specific CAP rate, or the CAP rate based on a specific price.
Example: A seller wanting $2 mil for a property will divide that price by the NOI to determine the CAP rate. This will not necessarily be a market CAP, but more of an asking CAP. Same Seller, pricing based on the Market CAP, will divide the NOI by the Market Cap rate to determine the price.
Settling on an accurate NOI usually tends to be the bigger issue, as buyers and sellers will each determine NOI based on their own assumptions. Sellers won't always include as many expenses as the buyers will when underwriting an investment.

Mar 28, 2013
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Chris F.
Salem, OR

Cap rates to me are one of the most frustrating thing in this business. They are miss-used and miss-understood. Cap rates are essentially a sliding scale index of risk-return reward. Typically things that drive cap rate include tenant quality, term of lease, market, location and property. The more favorable these are, the higher the cap rate should theoretically slide (down for higher value). Cap rate also effects value, if you take the property NOI and divide it by the cap rate, you have a value. But listing a property at a 6% cap rate when all your offers come in at 8%, what is the value of building and what is the cap rate? Until the property sells, it is difficult to determine the validity of a cap rate associated with it as the market determines the cap rate, not the seller, not a broker, only when a buyer and a seller come together and agree on what the value of the property is can a cap rate really be derived. It is essentially a risk return that both the buyer AND seller agree on.

Apr 4, 2013
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Glen W.
Lender/Mortgage Broker
Atlanta, GA

Cap rate determines the value of the property; the calculation is (Revenue-Expenses)/cap rate. Many times when folks are looking for properties they will require a certain cap rate (ie return) which can then drive the purchase negotiations

Apr 17, 2013
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Jonathan.E R.
Agoura Hills, CA

Each investor has his own way to look at his investment. Some look at the cap, some on the GRM some cash on cash. So cap rate is not a major decision maker. The property potential is a big decision. The location determents the value of the property and the cap rate. You can buy the best looking property in C location the potential of this property within 10 years is less than buying a property in A location. More C locations were in default than in A location. The real answer is what are you as an investor wants the return on your money to be. It is all about timing. When to buy and when to sell. Good luck To all of us.

Apr 18, 2013
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Michael S.
Houston, TX

Both actually.
The "market" will generally determine the actual cap rate but the rate used for a particular building will vary depending on a number of factors.
1.) creditworthiness of the tenant: International credit companies will obviously trade on a lower cap rate than start up companies due to the level of risk to the investor (thus, desire for a better return)
2.) lease rate (is is "market" ?): A building with a lower than market lease rate might trade on a lower cap rate since there is obvious "upside" to the deal. However, a higher than market lease rate might deter someone from paying the same cap rate since there is the risk that the investor will not be able to achieve the same lease rate if/when the tenant vacates the property
2.) amortized improvements: In some cases, there may be a high amount of improvement costs which were amortized into the lease. This may make the rent higher than "market" (see above), thus, impacting the actual return which the investor will require. In these cases, you can back out some of the amortized costs and apply the cap rate to the "base" rent with the investor paying the NPV of the amortized amount on top of the cap rate price.
4.) location of the site: Sites with more desirable locations may trade on a lower cap rate due to the fact that there is a higher potential for an increase in value which comes OUTSIDE of the investment value. Basically, this is just the same old adage of "location, location, location playing a role in the property value.

Apr 26, 2013
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