Office Cap Rates
Office cap rate = NOI / Transaction Price According to textbook definitions (Greer and Farrel, 1992) the cap rate is the ratio of the projected NOI during the first year of the holding period over the price at which the property is bought by the investor. Based on this definition the accurate mathematical formula for estimating an office cap rate is: CRt = NOIt+1 / TPt Where: In particular, office capitalization rates were found to be influenced negatively by the strenght of local office market conditions. In other words, when the local office market is strong with strong absorption, rising rents and decreasing vacancy rates office capitalization rates are decreasing. On the contrary, when the local office market is weak, with low absorption, high vacancy rate and declining rents office capitalization rates are low. Office cap rates are also influenced by national capital market conditions and interest rates. In particular, as interest rates and mortgage rates decline office cap rates decline as well for two reasons. First, office property in particular and real estate in general are competing for investment capital with alternative risky assets such as bonds and stocks. According to the capital market theory, return requirements by investors for all risky assets are influenced by the risk-free rate, that is, the interest rate. Since office propety and real estate is a risky asset it is also influenced by movements in interest rates in a positive way. In particular, when interest rates decrease office capitalization rates should decrease as well, assuming that all other factors that drive their movements (such as local market factors) do not change.
Office cap rates are influenced by interest rates for another reason. Note that the capitalization rate represents in essence the income return that the property provides to the investor. Note also that when interest rates decline mortgage rates decline too. Furthermore, most office property acquisitions involve the use of borrowed funds. Keeping the loan-to-value (LTV) ratio (that is, the percentage of the purchase price financed through borrowed funds) constant, a lower mortgage rate would allow investors to be able to service the loan with lower property income, which implies lower income return if we keep the price constant. Under such circumstances, and keeping constant all other factors that affect cap rate movements, investors would be encouraged to accept a lower income return and, therefore, a lower cap rate, when acquiring an office proeprty. Real estate investors and professionals should have in mind that while office capitalization rates are influenced by local office market conditions and national capital market influences, property-specific cap rates are also influenced by the return prospects and risks of the specific property under consideration as it compares with the local office market average return prospects and risk. For example, if the office property under consideration has greater appreciation prospects than the market on average then it should command a lower capitalization rate compared to the market average. Similarly, if the office property under consideration entails greater risk than the market average (due for example to higher vacancy rate or poor location) then it should command a higher capitalization rate. In particular, office properties with poorer condition and quality, as well as inefficient or inadequate technological/mechanical equipmet, should command a higher cap rate because the risk of higher operating expenses and/or leasing risk is greater. Similarly, office properties at poorer locations should command a higher cap rate due to higher leasing risk. Office proepties with strong credit tenants should command a lower cap rate than office properties occupied by tenants with poor credit due to lower uncertainty in terms of the future income earned by the property. Similarly, office properties with shorter leases should command a higher cap rate compared to properties with long-term leases for the same reason. Finally, office properties with lower occupancy should command a lower cap rate due to higher leasing risk. In the case of development of office buildings (as opposed to acquisition of existing office buildings) there are additional risk factors associated with the development process. For example, an office project that has secured a building permit is less risky than a project that has not secured yet a building permit. Similarly, a project that is 80% completed is less risky than a project that is only 10% completed. Both the permitting process and construction process involve risks. For example, unless the building permit is obtained the investor can not be sure about the exact nature of the project that is acquired as any existing designs may be changed at the request of the local authority as a requirement for providing the building permit. Furthermore, there are significant additional risks in the construction process, as the eventual cost of the project may prove to be higher than what was budgeted originally due to delays and increases in the cost of construction materials and labor. In addition, there is uncertainty in terms of the quality of the construction that will be eventually delivered by the contractors, as it may deviate from design specifications due to poor execution and construction monitoring.
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