What is A Cap Rate?

A capitalization rate (or cap rate) determines the valuation of income producing business properties by measuring the ratio of Net Operating Income (NOI) to the sales price. A low cap rate signifies more safer and stable investment opportunities. Higher cap rates indicate more risk for the buyer and hence discounted valuations. The net operating income is pre-tax and excludes depreciation and amortization charges, interest payment costs, and capital expenditures. Investors use the advertised cap rates on investment properties for sale as a way to quickly gauge the relative value of an investment opportunity. Cap rates are generally 5-10% and may be affected by the attractiveness of the property, the expected growth (or decline) of the investment opportunity, and current interest rates.

Cap Rates A Tool for Business Valuations

For businesses that are attached with real estate, cap rates are a useful valuation tool which allow potential buyers to compare their expected rate of return with other investment opportunities. Note that cap rates in the world of business sales are not used for businesses that are not attached to real estate. Common situations where businesses are attached to real estate and where cap rates may be used are private schools, gyms, and car washes. These businesses must operate in specially designed and constructed real estate venues, and can not easily be moved to another location. Because the owners of such businesses still wish to maintain their confidentiality in the event of a sale, they often choose to hire professional business brokers rather than typical commercial real estate brokers.

Growth Rate Affects Cap Rate

A major factor in determining the cap rate for a commercial investment opportunity is its expected growth rate. If future growth is expected, then the NOI used to calculate the cap rate will be expected to increase years into the future. Investors will be more inclined to pay a higher price (or a lower cap rate) if the future income stream of an investment property is expected to rise. Determining future growth may be addressed by a buyer during formal due diligence. The financials of the business may be examined to reveal the past growth rates (a strong indicator for future growth). Further, trends that signify future growth may be examined such as new product or service offerings, growing end-market demand, and strong customer satisfaction. Sellers will realize a higher selling price (and buyers will realize a lower cap rate) if the business underlying an investment property is growing.

Condition of Underlying Real Estate Affects Cap Rate

Another major factor in determining an effective cap rate is the condition and attractiveness of the underlying real estate and its physical assets. A well maintained property in an area that has growing commercial real estate values will have a lower cap rate (and a higher selling price) than a property that is in need of major repair or has an unattractive location. Investors using cap rates should employ their own due diligence in researching the local geographic region as well as the underlying real estate in determining the relative merits of commercial real estate opportunities.

Interest Rates Affect Cap Rate

Higher interest rates generally result in higher cap rates. This will in turn lower the market value of a commercial investment opportunity. When interest rates are high, investors know that they can effectuate a decent ‘risk free’ return on their investment simply by buying United States Treasury Bonds. Thus, investors can compare this ‘risk free’ return on their investment dollars with potential investments from income-producing investment properties. The potential investment opportunities must compare favorably with the risk-free returns by providing a significantly higher cap rate. The resulting ‘risk premium’ (or the difference in the rate of return between the investment opportunity and the ‘risk free’ rate of return) ebbs and flows with market conditions and changes in interest rates.

Example of Business Sale Using Cap Rate

Let us suppose that John owns and wishes to sell a car wash including its underlying land and property.
John consults a business broker because he wants to keep the sale of his car wash confidential so his employees, competitors, and customers do not know about the sale.
The business broker evaluates the car wash by first uncovering its net operating income (NOI).
Determining the NOI begins by examining the gross sales from the most recent financial statement, and deducting all operating expenses.
For purposes of determining the NOI, the costs of debt or principal payments as well as capital expenditures (including any resulting depreciation charges) are not included as regular operating expenses.
The business broker calculates that in the most recent annual period, the NOI of the car wash is $300K.
As the next step in the evaluation process, the business broker must set a proper cap rate.
To do so, the business broker observes that the current interest rate of risk-free U.S. Treasury bonds to be 5%.
Further, the business broker observes that the financial performance of the car wash shows strong growth, the car wash is situated in a growing geographical area with good visibility, and the physical condition of the property is excellent and well maintained.
The business broker thus sets the cap rate at 8%, which is 3% higher than the ‘risk free’ rate of return.
The 8% cap rate compares favorably with other similarly situated car washes for sale in the area.
John’s car wash should thus sell for approximately $3.75M, which is calculated by dividing the NOI by 8% (or $300K/.08).

Cap rates when used properly for businesses with attached real estate are a valuable tool in determining correct business valuations. Factors such as current interest rates (and their trajectory), the growth rate of the business, and the physical condition of the underlying property all greatly affect the cap rate. Business owners with attached real estate who wish to keep the sale of their business confidential should consult a professional business broker when it comes to sell their valuable assets.

Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.