• Mon. Nov 28th, 2022

Small: CAP rates and commercial real estate Aspen | Company

ByWillie M. Evans

Aug 22, 2022

Capital, whether equity or debt, is the lifeblood of the investment property industry. The availability and cost of this capital has a direct impact on the dynamism of commercial real estate markets and property values. The relationship between the cost of capital – better known as the interest rate – and the rental income rate of a property, known as a property’s capitalization rate (CAP rate) is one indicators used by investors to determine the attractiveness of a return for a property. investment in a particular investment property. For those unfamiliar with the terminology, a CAP rate is the net operating income (NOI), or initial yield, of an investment property divided by the price of the property. If you’re talking about fixed income bonds, the CAP rate would basically be the bond’s interest rate. Since income from real estate investments generally increases over time, the CAP rate is not only the initial return, but also an approximate projection of future returns.

The CAP rate an investor is willing to pay for an investment property is related to the investor’s view of what the building is likely to produce in future cash flows and the likelihood of receiving that cash flow, otherwise known as a risk factor. The higher the investor’s expectation of future net operating income (NOI), the greater the net cash flow received by the investor, and their confidence in the certainty of actually receiving that cash flow, the higher the rate CAP that the investor will pay for the investment is low. The lower the investor’s expectation of the future NOI and the higher the risk of receiving the future cash flows, the higher the CAP rate the investor will demand upon purchase. During the first half of 2022, the average CAP rate across the country for all types of commercial real estate investments was 250 to 300 basis points higher than the yield on 10-year Treasury bills, compared to an average of 290 basis points. basis from 2013. -2018. With current 10-year Treasury yields around 2.8%, the national average for CAP rates would be between 5.3% and 5.8%.

As the Aspen commercial real estate market emerges from two years of the COVID pandemic and record influx of tourists, new home buyers, new restaurants and international retailers, we have seen substantial increases in commercial rents. Over the past decade since the Great Recession, commercial rents have increased an average of 7% to 12% per year, depending on the location of the property, with much of this increase occurring in the past two years. By comparison, over the past four decades, commercial rents in Aspen have increased on average about 7.5% per year. The main reason for this strong rental growth has been very tight supply due to zoning pressures combined with long-term demand from businesses wanting to locate in Aspen, resulting in extremely low vacancy rates compared to to other more typical markets in the country.

In this context, one of the main questions asked by owners, investors and appraisers is: what is a CAP rate for Aspen commercial real estate in the investment market? current ? The best method to answer this question is to do a discounted cash flow analysis where a variety of factors are considered including available financing, projected rental appreciation, whether the property in question has existing rents below, above or equal to market rents, potential risk factors such as tenant defaults or vacancy, and what investors consider to be a reasonable return on investment. A good starting point for determining a reasonable return on equity invested in real estate would be the stock market. Over the past 90 years, the S&P 500 has produced an estimated compound average return of 10.5% per year.

Using reasonable current market assumptions for vacancy and credit losses, Aspen’s historical long-term average commercial rent appreciation of approximately 7.5% and a reasonable projected annual return on equity invested about 10% to 11%, you can run a discount cash flow analysis model to get an approximate CAP rate. The financing used in this model is a 50% loan on the purchase price with a debt coverage ratio of 1.25 amortized over 25 years at an interest rate of 5.4%, which is a reasonable financing in today’s market.

The result produces a CAP rate of about 4.5% for an average commercial property in downtown Aspen, about 100 basis points (i.e. 1.0%) below what the best real estate investment might sell in other parts of the country. CAP rates are used in the investment property industry as a bottom-up approach to reach a rough starting point for the valuation of commercial properties, so this benchmark CAP rate may vary depending on a certain number of factors, including interest rates on financing. As mortgage interest rates have increased over the past year, CAP rates have also increased.

Ultimately, the price at which an investment property might be sold largely depends on the needs of the investor and the unique characteristics of the property that might make it more or less valuable. The CAP rate approach to valuation is only a starting point.

Lori and William Small, CCIM are recognized experts in luxury and commercial real estate at Coldwell Banker Mason Morse in Aspen. They can be found via their website theSmallsaspen.com or by email at [email protected]