There is always healthy debate in property circles around Cap Rates and investors, sellers and buyers bandy them around, often without really understanding what the exact underlying make-up of the particular cap rate being talked about is.

As a Cap Rate is the Annual Gross income less expenses (Net income before interest) over the value / cost of the property one needs to understand the three components which make up this formula and how they can have a bearing on the overall outcome.

The gross income is not generally a major issue to quantify and it is generally contracted income in the form of leases so it is relatively easily determinable. The only real variable issue on the income side applies when there are vacancies in the asset and the determination of the market related rentals to be applied to the vacancies can have an element of subjectivity to it, as can the vacancy factor being used to factor in the risk to the income stream.

The expenses seem to cause the most confusion in Cap Rate interpretation as these are generally understated by sellers as it is in their best interest to do so. To explain my point let’s assume a retail property requires four cleaners and eight security staff to be managed, at a property in a suitable long term sustainable manner. The seller however wants to optimise his selling price at a particular yield so they cut staff to temporarily boost the net income. In our example let’s assume they cut one cleaner and three security guards per shift. This allows them to scrape by from a service level point of view in the short term whilst selling the property. Along comes the buyer and unbeknown to them the net income has been technically inflated by R576,000 (3 guards x R7,000 x day and night shift x 12) plus one cleaner at R6,000 x 12 = R72,000 totalling R576,000. At a 10% Cap Rate this additional income attributes R5,760,000 in additional value to the property.

The new owners then discovers 6 months after transfer that they are having issues with security only to be advised that the staff complement was cut prior to them taking transfer hence the inadequate service levels they are experiencing. The buyer then has to make the difficult choice to allow the property to be undermanaged or re-employ some or all of these staff leaving them well short of the yield they believed they were achieving.

The key therefore is to evaluate the expenses being used in calculating the Cap Rate or value is to ensure they are comprehensive enough ie they cover all the likely expenses required to operate the property and entity and that they are market related. Most of all they need to be sufficient to operate the property in a suitable long term sustainable manner. Unless you have a pretty good understanding of the expenses being used in the Cap Rate you are really in the dark as to what the Cap Rate should really be.

Repairs and maintenance can also be horribly understated by sellers or quoters of Cap Rates and only a detailed history of the R & M expenses incurred by the seller will reveal any underlying issues like ongoing roof leaks and plumbing problems. that may result in above ordinary maintenance costs and thereby negatively affect net income more than expected.

Finally on the issue of expenses there are also costs like bank charges, audit fees, legal fees and the like which are almost always get left out of Cap rate calculations. In our view these are genuine, actual costs associated with the property ownership and must be taken into account or you are kidding yourself about the actual return you are achieving. We like to work with net yields which take everything related to the particular property and the property owning structure into account so that we know exactly what return we are achieving and we can then also compare apples with apples.

The Cost / Value of the property is also subject to some manipulation and there is also some debate as to what the total costs should be included. Again we believe it should include all of your costs associated with acquiring and owning the asset and any costs that you will incur in the short term to maintain the property ie a coat of paint or a roof repair to get it back up to standard should also be included to make it a net yield. Again if you do not do this realistically you are misrepresenting the actual return to yourself.

If a Cap Rate is being used to calculate a value then this again has a lot of subjectivity to it. Here location, age and state of the property, lease profile, interest rate outlook, competition from other asset classes and the associated risk with the particular asset all play a roll. All of these are pretty subjective as risk can be real and or perceived. Someone with no bad experiences may not perceive any risk at all and someone with a lot of bad experience may in fact perceive more risk than there actually is.

Whichever way you use the formula, all the components of the Cap rate / Value calculation all have a fair amount of subjectivity and wriggle room to them which can easily be manipulated to serve a particular purpose. One might be forgiven for asking how you might ever arrive at a realistic, fair Cap Rate. To answer that question, one generally has to have extensive property knowledge and experience to guide you in determining what the correct expenses, income, risk and the corresponding Cap rate should be and even with this in place there will still be a degree of subjectivity involved.

The point we are making here is that you need to be very wary of liberally quoted cap rates and the next time someone bandies a Cap Rate around take it with a large table spoon of salt as it is highly like that some and if not all of the components of the formula being used have been manipulated, conveniently forgotten about and or quietly misrepresented to suit the person quoting the Cap Rate.

Until you have done a detailed and extensive due diligence with the required experience and expertise required to do so, you will never really know what the reality is behind the Cap Rate being bandied about.

Once you know more realistically what you are dealing with can you then attribute value and then consider whether the investment and the Cap Rate will suit your investment strategy or not. When comparing one Cap Rate to another one must also ensure that the methodology of the calculation used in the Cap Rates was the same so that they can actually be meaningfully compared.

It is generally accepted that Cap Rates are bench marked against government bond such as the R157 which is considered a relatively risk free investment. The premium on top of that rate is the risk premium associated with the asset in question. As an example the current R157 rate is 6.8%. One then needs to add the risk premium which will then apply from a range of a solid 10 year triple net lease with a listed company which would be around 8% to 8.25% to a less attractive assets which can go up to 15 to 16% depending where they lie in the risk spectrum.

In simple terms, it comes down to what you can earn from the asset with no risk plus the premium for the inherent risk associated with the asset. Historically, this risk premium is decided by the investor and their perception and appetite for the risk associated with the asset.

The final major factor influencing cap rates can be typical supply and demand conditions and a high demand from buyers will push cap rates down and values up. This essentially compresses the risk premium you are able to apply if you want to buy a particularly sort after property. In a nut shell this means you are exposing yourself to more risk than you should be and more importantly you are not getting the required return to offset the risks you are taking by paying the premium for the asset.

The decision ultimately lies with the purchaser to determine whether or not they are happy with the return on their investment and that this fits with their particular investment strategy. The key in making this decision is to know exactly what is in the return or Cap Rate so when you are making a decision on how much risk premium to add you are doing so on the actual return being achieved and not pulling the wool over your own eyes.