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COVID-19 Presents a Cautionary Tale About the Use of Capitalization Rates

COVID-19 has fundamentally changed the way we live and the way in which businesses operate. The real estate industry has been significantly affected in every aspect. The demand for certain types of commercial real estate, such as retail and office space, has fallen sharply and continues to struggle as the country tries to get back to normal amid the challenges of achieving herd immunity and the emerging variants of the virus.

Asset owners, operators, and potential investors are keeping a keen eye on the valuation of real estate assets. One of the key metrics used to value commercial real estate is the capitalization rate (also referred to as cap rate). Investors should strongly consider whether the cap rate, as commonly used in the industry, is an appropriate measure for the valuation of real estate assets during this unprecedented time.

What Is a Cap Rate?

A cap rate is the expected ROI (return on investment) on a real estate investment property, which is calculated by dividing NOI (net operating income) by the asset value of the property. NOI is the property’s annual revenue less operating expenses, such as regular upkeep, maintenance and property taxes. Revenue should consider vacancy rates and operating expenses should exclude large one-time costs such as major repairs, tenant improvements, capital expenditures, mortgage payments (including interest), depreciation and income taxes, if applicable. The formula tells us that a property that generates a higher NOI and has a lower property value will derive a higher cap rate. If we rearrange the formula holding NOI constant, a higher cap rate will result in a lower property value. Thus, a higher cap rate correlates with lower returns and higher risk, while a lower cap rate correlates with higher returns and lower risk.

Since the cap rate is one of the most common measures of profitability and likely ROI of real estate assets, it is critical to understand and evaluate the inputs into the calculation, as there likely were changes to the normal operating activities of properties because of the pandemic. Due to the burden placed on tenants’ businesses, which could have affected their ability to pay their bills, many landlords extended lease concessions or abatements and renegotiated leases and payment terms with their tenants, as was commonplace during the peak of the pandemic. Scenarios like this may affect the ability to forecast NOI, which in turn could potentially distort the cap rate. For these reasons, it is paramount that real estate valuations based on cap rates be vetted carefully and take into account the instability of the real estate market over the past 18 months.

Author: Jonathan Bhulai, CPA | jbhulai@withum.com

For more information or any questions, please contact a member of the Real Estate Services Team.

Real Estate Services

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