Cap Rates for Beginners

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By John Robinson
Managing Director
Jones Lang LaSalle

A capitalization rate — or cap rate — is defined as the yearly net operating income (NOI) divided by the total cost of the asset. It is also known as the buyer’s anticipated rate of return for the asset purchase.

Cap rates fluctuate based on market, product type and a variety of factors including interest rates and current returns posted by equities. Essentially, the markets with the most demand have lower cap rates. A lower cap rate means more buyers are interested in the investment, thus competitively driving the anticipated returns down.

Traditionally, larger office markets like New York, Washington, D.C. and San Francisco have the lowest cap rates. These markets attract capital from both domestic and offshore investors, creating more competition. Cap rates in second and third tier office markets like Indianapolis, Minneapolis and Nashville always lag behind the major markets. Typically, though, when cap rates fall below a certain point in major markets, investors broaden their geographic considerations in search of better returns.

At the office market’s peak in 2005 to late 2006, we saw cap rates get as low as 4.0% in major markets and 7.5% in second-tier markets. According to Real Capital Analytics, average cap rates fell from 10.0% to 5.5%. That means it was a seller’s market for office buildings during those years. Cap Rates in the Indianapolis office market currently range from 8.5% to 12.0%. In comparison, the five-year trailing average return on the S&P 500 is 4.86% and the three-year trailing average is 11.86%.

Keep in mind that buildings without stable, current cash flow (ie, ones with big vacancy problems) do not sell based on cap rates since the NOI is non-existent or unreliable. Typically, those buildings are measured on a cost-per-square-foot basis.

Chase Tower, a 1.1 million-square-foot Class-A trophy high rise in the CBD was sold in 2012 by Jones Lang LaSalle at an 8.3% cap rate. In theory, Chase Tower, with its trophy classification and 97.0% occupancy, should be the market leader for cap rate value.

Currently in Indianapolis, demand is high and supply is low for office buildings. Even as we emerge from the ongoing economic challenges, cap rates continue to fall and buyers are starting to be priced out of the major markets. I believe one of the main reasons for this is that vacancies are falling and lenders have kept a lid on new speculative construction, which keeps supply down.

Happy investing!

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