CRE Valuations and the use of CAP RATES in isolation will only produce an ROI of year 1 only!
Cap Rates for CRE valuations are used extensively all over the world but are in no way sufficient in producing the intrinsic value or even comparing investment returns between two Commercial Real Estate opportunities or valuations.
The need for NPV, IRR and MIRR cannot be overstated, as it is the only International formulae that will correctly take into account all valuation factors such as Annual Lease Escalation percentages, Growth percentages, Gearing effects etc. It is very easy to make huge mistakes by applying a standard Cap Rate to a certain sector and geographical location.
EXAMPLE: Prop A (2 850 000 net annual lease income with 6.35% annual escalation), and Prop B (3 000 000 net annual lease with 5% annual escalation) are painted with the same brush and a 6% Cap Rate is used for Valuation purposes. Implying that the values are (47 500 000 and 50 000 000 respectively). When one has a closer look, Prop A will be snapped up far quicker because it produces an IRR over 10 years at (12,35% as opposed to Prop B producing only 11%). This is because the Cap Rate method is unable to measure ROI beyond year 1 and also unable to calculate the lease escalation difference. This is against the backdrop of COC returns (ungeared).
Now we add gearing at 50% with funding rates at 6.75%:
Prop A produces an IRR of 14,72% and MIRR of 14,55% whereas Prop B produces an IRR of 12,91% and MIRR of 12,81%.
Prudent Investors will target a certain IRR % and more importantly the MIRR % and will then adjust the Cap Rate accordingly. At PROPPRO247.COM we automate the valuation process with basic lease input data and produce all the Cash flows, Exit Values, NPV, IRR and MIRR. Learn more about the simplicity of accurate CRE Valuations on our Learner Page (PDF downloads or YouTube Video explainers)