Cap Rate Vs. Cap Rate Vs. Cap Rate

It can drive you mad to try to understand what people are talking about and it nearly did. I was listening (hears dropping) to different commercial real estate professionals speaking about property valuation, I had problem understanding why the conversation was so lively. Then I realize that the different people involved in the conversation were comparing apples and oranges. They were using in the discussion two different cap rates one use to value a property for transaction purpose and one use for financing purpose.

While the two cap rates discussed should be the same, in numerous cases they are not. Here is our take on the differences between these cap rates and why they exist. To start with there is always some difference between transaction value and finance value, it is a classic one in real estate, it is experienced both in residential and commercial. If a buyer was acquiring a property for cash it is somewhat irrelevant to care if the cap rates are different. Recently, I was peripherally involved in a transaction where we had estimated the price of a property at a different level than what the sales price was. The buyer did not care to pay more for it, as they wanted the asset, they were going to put more down payment. The difference of cap rate does matter when the buyer needs financing or when a property owner needs refinancing. Most investors need but also wants financing for leverage purposes, thus the importance of the financing cap rate.

Cap Rates are somewhat market specific, but somewhat not. In addition different property types will have different cap rates, we are now speaking of 3 different cap rates. They are all linked to income, income growth and property liquidity. The more a property is seen as liquid the lower a cap rate could be. In this case liquidity can be defined as demand for a property type, financing available to it etc… For example in today's market, there is no liquidity for gas station property and there is no financing available, thus cap rates will be high. A seller and / or real estate transaction person will look at potentially lower cap rates since it supports higher valuation. A finance person who look at risks will consider higher cap rate since it takes into consideration numerous different short and long term factors.

The right cap rate is the one at which the transaction and / or refinance close. Where it can be a problem to have two or three cap rates, is when it comes time to refinance if a buyer has paid a property for cash. Another problem can happen when it is a development and reality vs. projections is different and initial valuations were overly aggressive. Today some property types in some markets trade with a differential, in other markets we are seeing either no difference or very small ones. In general I recommend to be aware of the different cap rates in your markets, the more informed you are the better decision you will make.