Show Buttons
Share On Facebook
Share On Twitter
Share On Google Plus
Share On Linkdin
Share On Pinterest
Share On Youtube
Share On Reddit
Share On Stumbleupon
Contact us
Hide Buttons

subscribe: Posts | Comments

Office Cap Rates

Office Cap Rates

Office cap rates reflect required income return by investors in the case of office property investment transactions.

The cap rate of an office transaction is estimated as the ratio of the property’s net operating income (NOI) over the transaction price, that is, the price at which an office property is acquired by the investor.

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

CR= Cap Rate
TP= Transaction Price
t = year t, during which the transaction occurs
t+1= year following year t

Office Cap Rate Drivers

According to empirical research by Sivitanidou and Sivitanides (1999) office cap rates are influenced by both local market conditions and national capital market forces. Extensive econometric analysis of historical data by these analysts has shown that local office market conditions influence local office capitalization rates at a greater exent than national capital market forces.

In particular, office capitalization rates were found to be influenced negatively by the strength 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 property 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 property and property 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 property.

Property 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.

Office Property Risk Factors

Risk factors do affect office cap rates. In the case of existing office property, all risk factors eventually are related with the net income that can be earned by the office property under consideration. Risk factors that may have an effect on the cap rate that an office property may command in the market have to do with the condition of the building, quality and functionality of its design, technological and mechanical equipment, the strength of its location, its occupancy rate, the credit rating of its tenants and the length of lease contracts of tenants that are in place.

In particular, office properties with poorer condition and quality, as well as inefficient or inadequate technological/mechanical equipment, 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 properties 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 cannot 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

Be Sociable, Share!