Capitalization rates are the primary valuation method for both buyers and sellers in the healthcare real estate industry. Although the cap rate is a basic concept in real estate, many owners and prospective buyers do not clearly understand the importance of this metric in property valuations.
As investor buyers are essentially purchasing a future income stream, the value of the real estate asset is primarily determined by the yield provided by that income stream. This overview is provided to help buyers and sellers of medical offices and facilities gain clarity on the role of capitalization rates in a property valuation and pricing.
The Basics: Cap Rates Defined
The capitalization rate (cap rate) is simply the ratio of an income property’s Net Operating Income (NOI) to the value of its property asset. For example, if a property has recently sold for $1,500,000 and its NOI was $120,000, then the cap rate is $120,000/$1,500,000, or 8%.
In the simplest terms, the cap rate reveals to an income property investor what percentage they can expect to earn if they buy the property with all cash. For example, if an investor thinks a property is worth a cap rate of 9%, he is expecting to obtain a 9% cash on cash return.
How Does the Cap Rate Reflect the Value of the Business?
A high cap rate means a lower property value. Conversely, the lower your cap rate, the higher your income property’s value. Divide your net operating income (NOI) by the cap rate to calculate your property value. This reflects your income stream, which is an important consideration in determining a sale price for your medical office facility.
Why are Cap Rates Used to Determine a Property's Value?
Real estate valuation involves a highly complex range of variables. Over the years professionals in the industry came to use the cap rate as the primary method of determining comparative property values in a market.
Using the cap rate is just one of three different ways appraisers value properties. However, it is the method with which investors are most concerned. It’s a popular approach, because it has proven to be an efficient method of correlating a market’s property values. It’s also helpful in making comparisons between markets.
What Assumptions Must be Applied in NOI Calculations?
The usefulness of cap rates in understanding the comparable value of properties in a market requires that the NOI is calculated on a consistent basis for all properties. For example, operating expenses must be of a similar nature and standard.
Assumptions regarding expenses are not so universally applied as those regarding income issues. Sellers and other parties to income property sales processes can have important misunderstandings about these.
Here are some essential assumptions that must be made when calculating NOI:
Assumption Regarding Income
Assumptions Regarding Expenses
· All revenues included in the calculation are from recurring operations of the property, such as rental revenues, vs. one time revenues such as an insurance reimbursement.
· Debt service and depreciation have not been deducted from revenues in NOI calculations. These costs are capital and tax matters, not relevant to calculating NOI.
• Property taxes have been adjusted to reflect the estimated amount of the new valuation at the time of sale.
• There is appropriate insurance on the property.
• Expense numbers reflect market rates for labor cost of operating a medical facility for services such as landscaping and maintenance. (If the owner is currently doing the work at no cost the market cost of the service will be considered an expense).
• Operating expenses are usually assumed to include a management. Depending upon property size, the fee is typically assumed to range between 3% – 5% of gross revenues.
Some owners may reason that these basic assumptions don’t apply to their properties, due to certain exceptions that they believe should apply. However, in reality, buyer’s will rarely consider any particular exceptions to the market standards.
Why Do Cap Rates Vary Between Properties?
The cap rate applied to a property is driven by market comparables. Like kind properties are assessed to determine the appropriate cap rate band to be applied to the specific asset. Hence, criteria such as location, quality of construction and tenant credit are considered.
Although cap rates vary, the fundamental assumptions regarding NOI do not. Admittedly, property valuations are, to some extent, subjective. However, industry professionals are well aware that experienced buyers and sellers do generally agree on NOI quality and on risk variances that exist within the narrow range of cap rates.
Do Cap Rates Truly Reflect the Medical Facility Market?
Cap rates are widely used in valuations because they are understood as accurately reflecting the marketplace. Nationwide, cap rate ranges do shift, as they have over the past decade.
Additionally, the market and sub-market a property is located in can have substantial impact on applicable cap rates.
High Cap Rates Versus Low Cap Rates
Capitalization rates have an inverse relationship to property value/price.
For Buyers — A high cap rate is most desirable for buyers/investors, because it indicates that the property value (purchase price) is low in contrast to the property’s actual income performance.
For Sellers — A low cap rate is more desirable for owners/sellers, because it indicates that the property value (purchase price) is high in contrast to the property’s actual income performance.
For an Ideal Valuation Based on Cap Rates
The most essential decision to be made in the property buying and selling process is determining the value of the property. This overview of cap rates has covered the most basic information about how the rates are determined and how they affect valuations. It can help you get a general sense of the value of your property or potential investment in one.
However, being entirely objective in factoring income and expenses, and especially in comparing your property to others in your local market for purposes of determining the appropriate cap rate can be challenging. Consult with a real estate expert whose focus is sale and purchase of healthcare real estate. There are various areas of specialized knowledge.