- The Washington Times - Friday, March 21, 2003

Amid discussion of an office building sale, real estate brokers throw around a lot of numbers.
One number, in the form of a percentage, sometimes gets lost in the discussion even though it's no less important than things such as sale prices and vacancy rates.
Call it the capitalization rate, or cap rate, for short.
Only a select few know what it means, and even fewer know how to calculate it.
So let's have a quick primer.
A cap rate is a number that describes the relationship between the income a building will provide a buyer, and the price that buyer paid for the building. Much like an interest rate or dividend yield, buyers use this number to get a sense of the potential success of their investment.
The cap rate is calculated by dividing the net operating income by the building's purchase price, or value.
So, if a building provides $1 million in income from its operations, and the buyer pays $10 million, then the cap rate is 10 percent. Generally speaking, a higher cap rate means a higher return on investment.
Cap rates have become a hot topic in commercial real estate circles in the District. These rates have slid in the past year, from between 9 percent and 10 percent in 2001 to 7 percent or 8 percent now. This means buyers of office space are willing to spend more on buildings even if the return on investment isn't as high as in years past.
"It isn't that rent rates have gone up, it's just that investors are willing to get less of a return," said Mary Peterson, senior vice president with Cassidy and Pinkard, a real estate services firm in the District.
Credit a slumping economy and stock market for this trend.
Warren Dahlstrom, a senior director in the finance division of Cushman and Wakefield, said investors often don't mind a low cap rate if it remains a higher yield than other investments.
A 10-year Treasury note is a good benchmark, he said. If there is a large difference between the two like now, when cap rates are more than twice the Treasury note yield then investors often turn to commercial real estate.
Foreign investors, especially European pension funds, have paid top dollar for office buildings in the District because the economies of Germany, Italy and other nations are slumping.
What's more, record-low interest rates have allowed investors to borrow more money to purchase buildings, so prices have not dropped much.
The District is one of the most stable office markets in the nation, even if cap rates are dropping. Government agencies and a host of defense and homeland security contractors make for credit-worthy tenants.
A stable tenant base can make the cap rate on a building's sale less important, according to Cliff Mendelson, head of the structured finance group at Transwestern Commercial Services.
A building filled with young tech firms might provide the same amount of operating income as the same building occupied only by a key government agency. But the government-filled building would command a higher price and thus a lower cap rate because the agency is not likely to find itself unable to pay its landlord.
In this instance, a low cap rate could simply be an indication that the buyer is willing to pay a premium for a good, solid tenant base, analysts said. And it demonstrates how a higher cap rate can indicate a building is a riskier investment.
So, if you happen to enter a discussion about the sale of an office building, remember that the term "cap rate" is not just real estate lingo. It's a key number that can be used to figure out whether someone is making a good or bad investment.
Property Lines runs Fridays. Tim Lemke can be reached at [email protected] or 202/636/4836.

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