Tuesday, August 28, 2018

Cap Rates Simplified - Market Value of Income Producing Properties

Do you know how to value income producing property? Let’s say you have a small office condo that you want to sell, and need to determine the value.  If there are recent sales of comparable condos, then it’s fairly easy to figure out.  But what about a ground lease of vacant commercial land?  

You’ll hear a lot about the “cap” rate and you will need a fairly good understanding of what the cap rate means to arrive at the market value of your land.  First, you’ll need to make sure there really is some demand for the land.  This usually happens in densely populated areas where most vacant parcels are already developed and land prices are very high.  For example, in a big city along a high traffic roadway.  Alternatively, large vacant parcels outside the densely populated areas may be suitable for a ground lease when the cost to buy and build is beyond a user’s budget.

Remember, a new ground lease is when the owner leases vacant land and the lessee (tenant) constructs their own building on the land.  The lessee controls the building and the land, and pays rent to the landowner for the entire term of the ground lease.  The tenant usually also pays the real estate taxes on the land and improvements. 

Even after the tenant constructs their building, the landowner can still sell the land, it’s just encumbered by a lease - which adds value to that land because it’s income producing property that requires virtually no maintenance or management.  The tenant owns and operates the building and the grounds.  The only management required is making sure the real estate taxes are paid, which is usually the tenant’s obligation but should be verified annually by the landowner.

So, to value this ground lease, you would apply a capitalization rate “cap” rate to the annual net operating income generated by the ground lease.  So, let’s assume the rental income is $2,000 monthly for the next 50 years (long term ground leases are common).  The annual income is $24,000 if the ground lease has a triple net structure (NNN).  So which cap rate to apply?  Let’s start with basic math here.  Say you heard a buyer was looking to pay for property with cap rates of 7 to 8 percent.  You could determine what price to charge that buyer based on his requirement by dividing 24,000 by 7 or 8 percent.  The sale price would be about $343,000 if the cap rate is 7% and $300,000 if the cap rate is 8%.  So, from a buyer’s perspective, the higher the cap rate, the lower the purchase price.  That’s why you’ll see sellers advertising well located income producing property with high quality tenants on long term leases at cap rates of 4% to 6% in a strong market.  And you’ll see buyers asking to buy properties at cap rates of 6% to 8%.  

Up next, how to determine the cap rate for your property from recent sales.

For more information, contact Sally Marks at 904-349-5192.

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