Let’s say you want to purchase an income property as an investment. As you conduct your search, you are likely to find that the stated property values are largely based on cap rates. While a cap rate is a decent baseline indicator of a general value range, it is typically not a reliable or accurate representation of the true long-term value of a particular property. There’s not an exact standard or consistent method for applying a cap rate – the factors and formulas used can be somewhat arbitrary. 

Cap rates are solely based on property income performance for the current year. Cap rates don’t take into consideration factors that may affect property values five years or 10 years down the road. Because cap rates only deal with what a property is producing now, it’s a very shortsighted and narrow view of property value and should not be the number on which you ultimately base your purchase price. 

I sometimes view cap rates as they relate to real estate the same way I consider the list price of a used car to its true value. Let’s imagine you’re in the market to buy a used car for your child’s 16th birthday and you’ve budgeted $4,000. You and Junior walk on to the lot and see some used cars with sticker prices of $8,000 or more. While you realize that the dealer will certainly sell the car for less than $8,000, you also know that he or she will not go down to $4,000. 

You walk past those cars until you see some options in the $4,500 to $5,000 range. Now Junior sees a car he loves and yells, “That’s the one I want!” So you get on your smartphone and pull up Kelley Blue Book to get an idea of what the car should be worth. At first you just put in the make, model and year and the formula calculates an estimated value of $5,500. But then you enter more data. More than 130,000 miles … bald tires … heavily worn upholstery … multiple dents from obvious fender benders … and now a more accurate valuation of the car shows that it’s not worth $5,500, it’s worth closer to $3,900. Whew! Aren’t you glad you took those other factors into consideration before agreeing to pay the sticker price or a price that was more than the true value of the car? So in this example, the sticker price is a decent indicator of price range, and can guide you to the right section of the car lot, but you need more information before you really know the value of the cars with any degree of accuracy.

Cap rates on income properties are often like the list price of a used car. They can be an indicator of the estimated value of the property and give you a starting point for your search, but there is more information and more work to be done before choosing a property and making an offer. 

Understanding the true, long-term value of a property requires a thorough analysis done by an expert who knows from experience what that analysis should include. There are many factors to consider when determining and fine-tuning property valuations. Here are a few of them:

• How good are the existing leases? A reputable grocery store with a 20-year lease is low risk; but a restaurant that’s empty most of the time with one year left on its lease is much riskier.
• Is there a good tenant mix and do they effectively serve the needs and interests of the surrounding community? The demographics of a community can change, and the types of tenants must evolve to match the needs and demands of the people in the area.
• What is the age and condition of the property? How soon will you have to pay for upgrades and repairs?
• What is the current housing market and financial environment like? Are rental rates rising or falling?
• What are the current interest rates and what are they expected to be in the coming months?
• Are operating and management expenses rising or falling? Here’s a hint – they’re usually rising.
• What are the historical occupancy, retention and vacancy rates for the property over the last 10 years to 15 years?
• What are the tax implications of buying a particular property?

I always recommend analyzing the cap rates and the values of each individual tenant, rather than looking at the property as a single entity. This provides a better picture of the actual risks that exist within a given property.

One common mistake that buyers often make is accepting income estimates that are based on 100 percent of projected occupancy rates. It’s like saying IF every space is occupied, and IF there is no time when a space is empty, THEN the property has the potential to generate a certain amount. If a cap rate is calculated based on 100 percent of a projected occupancy when the actual occupancy rate is 60 percent, you’re likely to pay too much for that property.

Typically, when you’re shopping for income properties, you’ll receive a sales packet that includes a lot of detailed information about the property. However, the information doesn’t do you much good if you don’t know how to interpret it and understand how it affects the property’s value. Plus, some packets have a lot of holes, so it’s important that you (or the people you’re working with) know which questions to ask. The bottom line is that revealing the true long-term value of a property is not an easy task, but it is necessary to determine a fair purchase price and ensure that you are making a wise investment.

Grayson Powell is a Managing Partner at Coldwell Banker Commercial Sun Coast Partners (CBCSCP). CBCSCP leverages the vast experience of highly-skilled real estate professionals and developers and specialize in selling, leasing and managing retail, commercial, and investment property. To learn more about CBCSCP, visit www.cbcwilmington.com or call 910-350-1200.