Uncertain cap rates disruptive

Value is commonly determined by looking at comparable sales as well as the income the property produces. Replacement cost is generally irrelevant for existing buildings because construction costs are so high and prices are well below replacement costs.

The Anchorage market has seen relatively few comparable sales because of few transactions. While lots of buyers are looking for property, owners have been reluctant to sell. I think the main reason is that sellers don't know what to do with the money from the sale. They think the stock market is too uncertain to invest in and with few properties on the market, they cannot easily exchange into another property. At a time of uncertainty, people tend to want to hold on to what they have.

Determining value based on income has become difficult because of problems determining what is called the capitalization rate, or cap rate. Cap rate is the return from real estate that has no debt. Cap rate is expressed by the ratio of income to value, and is used to convert income to a value.

For example, a property worth $1 million that produces $100,000 in income (before tax and not including depreciation) would have a 10 percent cap rate, (100,000/1,000,000 = .10). Or another way to look at this: A property with $100,000 of income at a 10 percent cap is worth $1 million, (100,000/.10 = 1,000,000).

Cap rates basically reflect the risk the property will continue to deliver cash flow from operation and eventual sale. The riskier the investment, the higher the rate of return an investor will require; the safer the investment, the lower rate of return will be required. (Note: High cap rate means higher return and lower price, while a low cap rate is lower return and a higher price.) For example, a property leased by a major national company will have a lower cap rate than if it were leased to a local company, because the risk is lower that a national company will not pay rent.

The specific cap rate is relative to the market interest rate for borrowed money and return on equity required by the investor. If the loan interest is 7 percent, an average cap rate would be about 1 percentage point higher, or 8 percent. A risky investment might be 2 percentage points higher, or 9 percent. But if the loan rate were higher, say 8 percent, then all the cap rates would move up.

A small change in the cap rate can make big difference in value. Take the above property with $100,000 of income. At an 8 percent cap rate, the value is $1,250,000. With a 7.5 percent cap rate, just 0.5 percentage point lower, and the value goes up to $1,333,000. But say interest rates go up and cap rate is 8.5 percent, then the value drops to $1,176,000.

For larger properties, say those worth more than $10 million, a buyer is apt to shop for financing outside the state, and predicting the loan terms for such financing is impossible. Here in Alaska, we generally do not have that problem because most of our properties are relatively small and local banks can finance them. But locally, loan terms have been less stable than normal, causing uncertainty for the cap rate.

Cap rates are also influenced by comparable sales' cap rates. With few comparable sales, this indicator is often not available, or the ones that are available are not really comparable. Surprisingly, this is showing up with local appraisers having to deal with the cap rates in the Lower 48. But the Lower 48 commercial market is in the tank with high cap rates, which some think should cause our cap rates to be at a higher level.

Particularly difficult at this time is determining what the investor requires for return on his equity. The market is so uncertain that investor-required returns are all over the place.

The uncertainty on cap rates is creating problems for everyone involved in a transaction, including the seller, buyer, appraiser and lender.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every fourth Sunday.