Price Gap Between Rent and Home Ownership in Chicago

The price gap between average apartment rents and the cost of owning a home in the Chicago metro area is widening, providing landlords with leverage to push rents even higher.

According to a recent report by RentCafe, the average rent in Chicago is now $2,215 per month. This is significantly higher than the cost of owning a home, which is currently $1,950 per month, including mortgage payments, property taxes, and insurance.

The widening price gap is being driven by a number of factors, including rising interest rates and strong home values. As interest rates have increased, the monthly cost of owning a home has become more expensive. At the same time, home values in Chicago have continued to rise, making it even more difficult for first-time homebuyers to enter the market.

The widening price gap is giving landlords more leverage to push rents. With fewer people able to afford to buy a home, demand for rental housing is increasing. This is putting upward pressure on rents, and landlords are starting to see more success in raising rents.

The widening price gap is also having an impact on multifamily net operating income (NOI). NOI is the money that a multifamily property generates after paying all of its operating expenses. As rents increase, NOI also increases. This can help to offset the higher commercial mortgage interest rates that landlords are facing.

In the long term, it is unclear whether the widening price gap between rent and home ownership will continue. However, in the short term, it is likely to continue to put upward pressure on rents and boost multifamily NOI.

Bottom Line

The price gap between rent and home ownership in Chicago is widening, providing landlords with leverage to push rents even higher. This is being driven by rising interest rates and strong home values. The widening price gap is also having an impact on multifamily NOI, which is likely to increase in the short term.

https://www.creconsult.net/market-trends/price-gap-between-rent-and-home-ownership-in-chicago/

Net Operating Income (NOI): A Beginner's Guide

Understanding Net Operating Income (NOI) is essential in commercial real estate. Without a firm grasp of net operating income, commonly referred to as just “NOI”, it’s impossible to fully understand investment real estate transactions. In this article, we’ll take a closer look at net operating income, discuss the components of NOI, and also clear up some common misconceptions.

What is Net Operating Income (NOI)

Net operating income (NOI) is the most widely used performance metric in commercial real estate. What is NOI in real estate? The net operating income is defined as the total operating income for a property minus the total operating expenses for a property.

The net operating income is useful because it describes a property’s ability to generate income without considering its capital structure. Since different owners will have different capital structures and financing costs, the NOI enables evaluation of property performance before taking any of these owner-specific factors into account.

The net operating income is often referred to as “the line” because operating expenses are calculated “above the line” while capital expenditures and leasing costs are “below the line” items.

Net Operating Income Formula

Net operating income (NOI) is the income generated by a property minus all expenses incurred from operations. The basic net operating income formula is as follows:

Depending on the property type or the parties involved, there is often some nuance in how the net operating income is calculated. For example, a multifamily property will have property-specific line items such as the loss to lease, while an office building will have line items for tenant reimbursements. In any case, at a high level, the net operating income formula is the same and measures operating income minus operating expenses.

NOI Meaning

NOI means Net Operating Income and measures the net income generated by a property before considering any owner-specific expenses such as financing. Net operating income is positive when effective gross income exceeds operating expenses, and negative when operating expenses exceed effective gross income.

For the purposes of real estate analysis, NOI can either be based on historical financial statement data, or instead based on forward-looking estimates for future years, which is also known as a proforma.

Net operating income measures the ability of a property to produce an income stream from operations. Unlike the cash flow before tax (CFBT) figure calculated on a real estate proforma, the net operating income figure excludes any financing or tax costs incurred by the owner/investor. In other words, the net operating income is unique to the property, rather than the investor.

Net Operating Income and Lease Analysis

The vast majority of commercial real estate income is generated by contractual tenant leases. Before we go over each of the components of NOI in more detail, let’s first take a quick detour into the world of commercial real estate leases.

Lease analysis is the first step in analyzing any income-producing property, since it identifies both the main source of income and who pays for which expenses. As you can see from the net operating income formula above, understanding this is essential to calculating NOI.

While there are many industry terms for different real estate leases, such as the modified gross lease, triple net lease, or the full-service lease, it’s important to understand that these terms can have various meanings depending on who you are talking to and which part of the world you are in. That’s why it’s critical to remember that the only way to understand a lease is to actually read it.

At a high level, leases can be viewed on a spectrum of possible structures.

On the one hand, you have absolute gross leases where the owner pays all the operating expenses related to the property. On the other hand, you have absolute net leases, where the tenant is required to pay all operating expenses. Everything else falls in between these two extremes and is considered a negotiated or hybrid lease.

How to Calculate Net Operating Income (NOI)

Calculating net operating income is relatively straightforward once you break out each of the individual components. The major components of net operating income consist of potential rental income, vacancy and credit losses, other income, and operating expenses.

Potential Rental Income – Potential Rental Income is the sum of all rents under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties.

Vacancy and Credit Losses – Vacancy and credit losses consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. For the purposes of calculating NOI, the vacancy factor can be calculated based on current lease expirations as well as market-driven figures using comparable property vacancies.

Effective Gross Income – Effective Gross Income (EGI) in the net operating income formula above is simply potential rental income less vacancy and credit losses. EGI is the amount of rental income that the owner can reasonably expect to collect from a property.

Operating Expenses – Operating expenses include all cash expenditures required to operate the property and command market rents. Common commercial real estate operating expenses include real estate and personal property taxes, property insurance, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.).

Net Operating Income – As shown in the net operating income formula above, net operating income is the final result, which is simply effective gross income minus operating expenses.

Although these are the high-level line items used to calculate NOI, the format of a real estate proforma can vary widely depending on the property type, intended use, sophistication of the parties involved, and more. For more complicated net operating income calculations, you might consider using our commercial real estate analysis software.

What’s Not Included in Net Operating Income

It’s also important to note that there are some expenses that are typically excluded from the net operating income figure.

Debt Service – Financing costs are specific to the owner/investor and as such are not included in calculating NOI.

Depreciation – Depreciation is not an actual cash outflow, but rather an accounting entry, and therefore is not included in the NOI calculation.

Income Taxes – Since income taxes are specific to the owner/investor, they are also excluded from the net operating income calculation.

Tenant Improvements – Tenant improvements, often abbreviated as just “TI”, include construction within a tenant’s usable space to make the space viable for the tenant’s specific use.

Leasing Commissions – Commissions are the fees paid to real estate agents/brokers involved in leasing the space.

Reserves for Replacement – Reserves are funds set aside for major future maintenance items, such as a roof replacement, or air conditioning repair. While the textbook definitions of NOI usually exclude reserves from the NOI calculation, in practice many analysts actually do include reserves for replacement in NOI. For example, most lenders will include reserves for replacement into the NOI calculation for determining debt service coverage and the maximum loan amount. This makes sense because lenders need to understand the ability of a property to service debt, which of course has to consider required capital expenses to keep the property competitive in the marketplace. To see how much confusion and disagreement there is on this, just take a look at all the various answers you see here on this Reddit thread.

Capital Expenditures – Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement. Note that capital expenditures are major repairs and replacements, such as replacing the HVAC system in a property. This does not include minor repairs and maintenance which are considered an operating expense, such as replacing doorknobs and lightbulbs.

While many of the above items are almost always excluded from net operating income, it’s important to remember that some are open to interpretation depending on the context. Keep this in mind when building your own proformas and when evaluating NOI calculations performed by others.

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Net Operating Income Example

The following is an example of a typical real estate proforma that would be commonly used by lenders, investors, developers, brokers and appraisers. It breaks out how net operating income is calculated and presented for an example warehouse property.

The net operating income line is calculated by deducting vacancy and credit loss from potential gross income, then subtracting out all operating expenses. Notice that the debt service and replacement reserves are not included in the NOI calculation.

Net operating income projections like this are regularly created by appraisers and other commercial real estate professionals. Once you have a projection of net operating income you can then calculate property level metrics such as the capitalization rate, yield on cost, development spread, IRR, NPV, and more.

Conclusion

Calculating NOI is an important step in evaluating and valuing a property. Once you have an NOI figure, you can begin looking at various measures such as the cap rate or a maximum loan analysis. Then you can also move on to a more detailed analysis that includes a bottom-line cash flow figure and a full discounted cash flow analysis.

Keep the above NOI formula in mind when calculating and reviewing NOI figures, and also be aware of what’s included and excluded from NOI, and you’ll have a good framework for understanding net operating income for any property.

 

 

Source: Net Operating Income (NOI): A Beginner’s Guide

https://www.creconsult.net/market-trends/net-operating-income-noi-a-beginners-guide/

Mason Square

Fully Equipped Car Wash For Sale
1250 Douglas Rd. | Oswego, IL | 3,750 SF | 6 Bays | 1.19 Acres
Mason Square Car Wash, a fully equipped and operational 6-bay carwash in southwest suburban Chicago’s Oswego, IL. Ideally located on an out-lot of the Mason Square Shopping Center along heavily trafficked Route 34, averaging 45,000 vehicles per day,
Listing Agent: Randolph Taylor 630.474.6441 | rtaylor@creconsult.net
https://www.creconsult.net/fully-equipped-car-wash-oswego-il-route-34/

How a Broker Price Opinion Works

The broker price opinion (BPO), also known as a broker opinion of value (BOV), is a popular way of estimating the value of a property. Typical reasons for ordering a broker price opinion include estimating value prior to purchase or sale, understanding collateral value when securing a new loan or refinancing, estimating liquidation value, buying out a partner’s interest in a property, among many others. In this article we’ll take a deep dive into the broker price opinion, review the three approaches to market value, and also clear up some common misconceptions about the broker price opinion.

Broker Price Opinion Template

Before we dive in, we have a handy broker price opinion template that you can use to build your own reports. It’s based on Microsoft Word, so you’ll be able to edit the details as you see fit. Grab it now, then follow along with the rest of the article.

Broker Price Opinion vs Appraisal

The primary difference between a broker price opinion and an appraisal is cost. Because a broker price opinion is less comprehensive, it is usually a fraction of the price of a full appraisal. It’s also important to note that an appraisal is provided by a third-party and is not biased in its estimate of market value. On the other hand, a broker price opinion is typically performed with the intent that the broker will ultimately win the listing, and as such the underlying motivations behind a broker price opinion may be different than that of an appraisal.

Broker Price Opinion State Regulations

It’s important to understand that regulations around broker price opinions are by no means uniform and vary by state. For example, some states only allow broker price opinions to be performed for very specific use cases such as an opinion on a competitive listing price, but not for other use cases such as a tax appeal. Different states have different regulations regarding broker price opinions and explicitly listing out all of these different regulations is beyond the scope of this article. It goes without saying that you should contact a lawyer before performing or ordering broker price opinions in your state to make sure you understand what, if any, restrictions exist.

Approaches to Market Value

The purpose of a commercial real estate valuation is to determine fair market value, which is the most probable price a willing and knowledgeable buyer would pay for a property given a reasonable amount of time to complete the transaction. Before we dive into the components of a typical broker price opinion report, let’s quickly go over the three primary methods used to determine market value.

Sales Comparison Approach
The sales comparison approach equates the value of a property to prices that buyers have historically paid for similar properties. Of course, in practice, no two properties are exactly alike. Typically the sales comparison approach takes into account comparable properties that were sold within the prior 6-12 months. This is arguably the most common method of real estate valuation and consists of the following steps:

1. Find comparable properties
2. Adjust the comparable properties found for each variance
3. Net the adjustments
4. Select the value, giving a greater weight to the properties with the most similarities

Overall the sales comparison method is most effective when the pool of available recently sold properties is large.

Income Capitalization Approach
The income based approach to market value is based on the idea that a property’s value is derived from the income it produces. The two methods used to value a property based on income are the direct capitalization method and the discounted cash flow valuation method.

The direct capitalization method simply converts a one-year stabilized net operating income (NOI) into a market value using a cap rate. This is done using the IRV formula which states that Value (V) = Income (I) / Capitalization Rate (R). To use this method you simply construct a proforma NOI and divide it by the appropriate cap rate (which is determined from recently sold comparable properties). If there aren’t any or enough recently sold comparable properties then the cap rate can be constructed using other methods such as the band of investment method.

The discounted cash flow valuation method is used when uneven cash flows are anticipated for a property. With uneven cash flows, the more simplistic direct capitalization approach does not take into account these variations in cash flow, and as such is not adequate.

Cost Approach
The cost approach bases value on the cost of reproducing a property, less any accrued depreciation. Accrued depreciation can come from three sources: physical deterioration, functional obsolescence, and external obsolescence.

Physical deterioration is the regular wear and tear that occurs due to exposure to the elements.

Functional obsolescence refers to the inablilty of an existing building to provide the same utility as a newly constructed building. For example, the ceiling height in an existing warehouse may not meet the requirements of modern day users, which could be easily accommodated with a newly constructed building.

External obsolescence refers to the loss of value due to external forces such as road closures, re-routed highways, traffic congestion, etc.

Once the replacement cost is determined and the accrued depreciation is netted out, the cost is added to the value of the land to determined an appropriate value based on cost. The reason why the cost approach is used is because a rational buyer would not pay more for an existing property than it would cost to construct a new building with equal utility. The primary limitation of the cost approach is that it does not reflect the forces of supply and demand, and as such, it is typically used when there is a lack of comparable properties.

Reconciliation of Value
In a full appraisal, and often times in a broker price opinion, the above values are typically reconciled by using a weighted average to determine the final value estimate. For example, it may be determined that a higher weight should be given to the income approach because the available comparable sales data is weak, and as such this would be reflected in the final reconciled value.

Also, it’s worth noting that in practice the cost approach is usually not considered in a broker price opinion. A broker price opinion typically only considers the sales comparison method and the income based approach.

Components of a Broker Price Opinion Report

While each individual broker price opinion report will vary based on the requirements of each specific property, the following components are commonly used in broker price opinion reports. Also, be sure to grab our broker price opinion template which includes sections for the below items.

Location Information – General information about the location of the property, including address, site map, aerial, building type and size.

Description of Site – More detailed information about the site, including ownership, visibility, and access.

Market Area Overview and Trends – Includes information about the market conditions of the trade area including employment growth, population growth, construction/development activity, trends in vacancy and lease rates, commentary on noteworthy local news, as well as a demographic summary and traffic count if applicable.

Subject Property Condition –  More detailed description of the subject property as well as commentary on its condition.

Tenant Information – A discussion of each of the tenants occupying the property including lease terms, lease expiration, industry, etc.

Current Comparable Listings – Photos and analysis of three or more current for sale listings of comparable properties.

Recent Comparable Sales – Photos and analysis of three or more recent comparable sales, including adjustments as well as a discussion of similarities and differences.

Proforma – A stabilized or multi-year proforma for the subject property showing Gross Potential Income, Expenses, and Net Operating Income (NOI).

Range of Market Values – This section should summarize the above sales comparison and proforma data by providing an estimated range of values based on the sales comparison approach and the income approach to value.

Broker Marketing Plan – While this section is not necessary, it is often included by the broker in hopes of winning the listing. This section includes a marketing action plan to market and ultimately sell the subject property.

Closing Thoughts on the Broker Price Opinion

The broker price opinion has become popular in recent years during the recession and banking crises, and due to the increased attention it will likely remain a popular way to estimate market value. While each individual broker price opinion will vary depending on the particular needs of the client and attributes of the property, the above framework should give you a good foundation for understand any broker price opinion.

Source: How a Broker Price Opinion Works

https://www.creconsult.net/market-trends/how-a-broker-price-opinion-works/

Akhan Semi

Absolute NNN Leased Industrial | Akhan Semiconductor
940 Lakeside Drive | Gurnee, IL 60031
Exp Commercial is proud to present to market an excellent opportunity to acquire an absolute NNN-leased state-of-the-art industrial manufacturing facility with zero landlord responsibilities at a below-market price with future upside in market rents and potential tenant expansion.
Listing Agent: Randolph Taylor 630.474.6441 | rtaylor@creconsult.net
https://www.creconsult.net/absolute-nnn-leased-industrial-akhan-semiconductor-gurnee-il/

Off-Market Multifamily Sellers Are Leaving A Ton Of Money On The Table

Off-Market Multifamily Sellers Are Leaving A Ton Of Money On The Table

Marketing a property can increase the sale price by up to 23%, which runs counter to the idea that off-market deals can achieve higher values because a buyer will be more aggressive to seal a trade.

The perception is when a seller has one buyer vying for an asset, that buyer is more aggressive and willing to pay a premium because they don’t want the seller to get into a bidding war for the property. Our research found the opposite.

This is a sign it is in the best interests of owners to undergo a marketing campaign for their properties. Growing allocations from institutional investors toward real estate are still driving a sizable pool of investors into bidding for multifamily assets, and a full campaign is what drives the premiums.

The job of a broker to create a competitive environment on behalf of the seller. Putting a building on the market determines the strongest buyer.

That may not be necessarily based on price alone. If one buyer has a higher-priced offer but weak financial backing, versus a buyer with a stronger track record, taking a lower offer is the way to go. It’s our job to give the seller those options and we do that by marketing properties and generating the highest number of qualified offers possible.

There are numerous case studies where a seller received an off-market bid, put it on the market, and the off-market buyer still bought the asset but at a higher price.

 

Have you thought of selling your property and would like to know what it's worth? Request a valuation for your property below:

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eXp Commercial Chicago Multifamily Brokerage focuses on listing and selling multifamily properties throughout the Chicago Area and Suburbs.

We don’t just market properties; we make a market for each property we represent. Each offering is thoroughly underwritten, aggressively priced, and accompanied by loan quotes to expedite the sales process. We leverage our broad national marketing platform syndicating to the top CRE Listing Sites for maximum exposure combined with an orchestrated competitive bidding process that yields higher sales prices for your property.

 

https://www.creconsult.net/market-trends/off-market-multifamily-sellers-are-leaving-a-ton-of-money-on-the-table/

The Cap Rate: What You Should Know

The capitalization rate is a fundamental concept in the commercial real estate industry. Yet, it is often misunderstood and sometimes incorrectly used. This post will take a deep dive into the concept of the cap rate, and also clear up some common misconceptions.

Cap Rate Definition

What is a cap rate? The capitalization rate, typically just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. So, for example, if a property recently sold for $1,000,000 and had an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.

The cap rate formula can also be re-arranged to solve for value:

Appraisers frequently use this relationship to estimate the market value for a property based on a cap rate derived from comparable sales.

Cap Rate Example

Let’s take an example of how a cap rate is commonly used. Suppose we are researching the recent sale of a Class A office building with a stabilized Net Operating Income (NOI) of $1,000,000, and a sale price of $17,000,000. In the commercial real estate industry, it is common to say that this property sold at a 5.8% cap rate.

To estimate the market value for a property, an appraiser might use several recent sales like this to derive a market-based cap rate for Class A office buildings. Suppose our Class A office building generates a stabilized NOI of $900,000, and we want to know what the building is worth. If an appraiser derives a market-based cap rate of 6% for our market, then we can divide our $900,000 NOI by 6% to estimate a market value of $15,000,000.

Intuition Behind the Cap Rate

What is the cap rate actually telling you?  One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase.  In the above example, assuming the real estate proforma is accurate, an all-cash investment of $17,000,000 would produce an annual return on investment of 5.8%.

Another way to think about the cap rate is that it’s just the inverse of the price/earnings multiple.  To find the NOI multiple for a particular cap rate, just divide 1 by the cap rate. For example, a 5% cap rate results in a value of 1/.05 or 20x NOI. Consider the following chart:

As shown above, cap rates and NOI multiples are inversely related.  In other words, as the cap rate goes up, the NOI multiple goes down.

What is a Good Cap Rate?

What’s a good cap rate? The short answer is that it depends on how you are using the cap rate. For example, if you are selling a property, then a lower cap rate is good because it means the value of your property will be higher. On the other hand, if you are buying a property then a higher cap rate is good because it means your initial investment will be lower.

You might also be trying to find a market-based cap rate using recent sales of comparable properties. In this case, a good cap rate is one that is derived from similar properties in the same location. For example, suppose you want to figure out what an office building is worth based on a market-derived cap rate. In this case, a good cap rate is one that is derived from recent office building sales in the same market. A bad cap rate would be one derived from different property types in different markets.

When, and When Not, to Use a Cap Rate

The cap rate is a very common and useful ratio in the commercial real estate industry, and it can be helpful in several scenarios.  For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties.  A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.

Another way cap rates can be helpful is when they form a trend.  If you’re looking at cap rate trends over the past few years in a particular submarket, then the trend can give you an indication of where that market is headed.  For instance, if cap rates are compressing, that means values are being bid up and a market is heating up. Where are values likely to go next year?  Looking at historical cap rate data can quickly give you insight into the direction of valuations.

While cap rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.

Components of the Cap Rate

What are the components of the cap rate, and how can they be determined?  One way to think about the cap rate is that it’s a function of the risk-free rate of return plus some risk premium.  In finance, the risk-free rate is the theoretical rate of return of an investment with no risk of financial loss.  Of course, in practice, all investments carry even a small amount of risk. However, because U.S. bonds are considered to be very safe, the interest rate on a U.S. Treasury bond is normally used as the risk-free rate. How can we use this concept to determine cap rates?

Suppose you have $10,000,000 to invest, and 10-year treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks. What if you were presented with an opportunity to sell your treasuries and instead invest in a Class A office building with multiple tenants? A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate to the yield on the treasury bonds.

Suppose the acquisition cap rate on the investment property was 5%.  This means that the risk premium over the risk-free rate is 2%.  This 2% risk premium reflects all the additional risk you assume over and above the risk-free treasuries, which considers factors such as:

• Age of the property.
• Creditworthiness of the tenants.
• Diversity of the tenants.
• Length of tenant leases in place.
• Broader supply and demand fundamentals in the market for this particular asset class.
• Underlying economic fundamentals of the region including population growth, employment growth, and inventory of comparable space on the market.

When you take all of these items and break them out, it’s easy to see their relationship with the risk-free rate and the overall cap rate. It’s important to note that the actual percentages of each risk factor of a cap rate and ultimately the cap rate itself are subjective and depend on your own business judgment and experience.

Is cashing in your treasuries and investing in an office building at a 5% acquisition cap rate a good decision?  This, of course, depends on how risk averse you are.  An extra 2% yield on your investment may or may not be worth the additional risk inherent in the property. Perhaps you can secure favorable financing terms and using this leverage you could increase your return from 5% to 8%.  If you are a more aggressive investor, this might be appealing to you.  On the other hand, you might want the safety and security that treasuries provide, and a 3% yield is adequate compensation in exchange for this downside protection.

Band of Investment Method

The above risk-free rate approach is not the only way to think about cap rates.  Another popular alternative approach to calculating the cap rate is to use the band of investment method.  This approach considers the return to both the lender and the equity investors in a deal.

The band of investment formula is simply a weighted average of the return on debt and the required return on equity.  For example, suppose we can secure a loan at an 80% Loan to Value (LTV), amortized over 20 years at 6%.  This results in a mortgage constant of 0.0859.  Further, suppose that the required return on equity is 15%.  This would result in a weighted average cap rate calculation of 9.87%:

The Gordon Model

One other approach to calculating the cap rate worth mentioning is the Gordon Model. If you expect NOI to grow each year at some constant rate, then the Gordon Model can turn this constantly growing stream of cash flows into a simple cap rate approximation.  The Gordon Model is a concept traditionally used in finance to value a stock with dividend growth:

This formula solves for value, given cash flow, the discount rate, and a constant growth rate. From the definition of the cap rate, we know that value equals NOI divided by the cap rate. This means that the cap rate can be broken down into two components, the discount rate, and the growth rate.  That is, the cap rate is simply the discount rate minus the growth rate.

How can we use this? Suppose we are looking at a building with a stabilized NOI of $100,000 and in our analysis, we expect that the NOI will increase by 1% annually.  How can we determine the appropriate cap rate to use?  Using the Gordon Model, we can simply take our discount rate and subtract out the annual growth rate.  If our discount rate (usually the investor’s required rate of return) is 10%, then the appropriate cap rate to use in this example would be 9%, resulting in a valuation of $1,111,111.

The Gordon Model is a useful concept to know when evaluating properties with growing cash flows.  However, it’s not a one-size fit all solution and has several built-in limitations.  For example, what if the growth rate equals the discount rate?  This would yield an infinite value, which of course is nonsensical. Alternatively, when the growth rate exceeds the discount rate, then the Gordon Model yields a negative valuation, which is also a nonsensical result.

These built-in limitations don’t render the Gordon Model useless, but you do need to be aware of them.  Always make sure you understand the assumptions you are making in an analysis and whether they are reasonable or not.

Cap Rate Cheat Sheet

Fill out the quick form below and we’ll email you our free cap rate Excel cheat sheet containing helpful calculations from this article.

The Many Layers of Valuation

Commercial real estate valuation is a multi-layered process and usually begins with simpler tools than the discounted cash flow analysis. The cap rate is one of these simpler tools that should be in your toolkit.  The cap rate can communicate a lot about a property quickly, but can also exclude many important factors in a valuation, most notably the impact of irregular cash flows.

The solution is to create a multi-period cash flow projection that considers these changes in cash flow, and ultimately run a discounted cash flow analysis to arrive at a more accurate valuation.

 

Source: The Cap Rate: What You Should Know

https://www.creconsult.net/market-trends/the-cap-rate-what-you-should-know/