Spring 2009 issue of Horizons

INDUSTRy u REal Estate Valuing Commercial Real Estate (cont.)

The significance of capitalization rates that change over time, or adjust to the “market,” is the effect on increasing or reducing investment property values. As a buyer, a higher cap rate is more attractive because it results in a lower purchase price. A seller prefers a lower cap rate that creates a higher property sale price. Hence, there is an inverse relationship between cap rates and property values. In the previous example, a higher market cap rate of 9 percent reduces the value of the property (and sale price) to $2,777,777, and a lower market cap rate of 7 percent bumps the property value up to $3,571,428. Consequently, a 1 percent shift in the “market” cap rate has a dramatic effect on the sale price of commercial investment property.

In the graph to the left, we see how market cap rates have trended over the last several years. In the Midwest, the average cap rate at the start of the decade was about 9½ percent and declined to about 7½ percent recently. The lowest average cap rate was in 2007, when a “perfect storm” was in place for investment property values to be at their highest. Four primary factors created this perfect storm: low interest rates, a robust economy, “easy money” from lenders, and an increasing demand for commercial real estate as an investment alternative. As all storms pass, this one did so in dramatic fashion. Today we find ourselves in an environment that is pushing cap rates up as all four factors have reversed. The availability of capital has diminished, and buyers’ demand for investment property has decreased. Also, the current economic conditions have many investors waiting to see what happens. However, while market cap rates have risen recently, resulting in lower property sale prices, cap rates have not climbed to anywhere near the 9 percent+ level we experienced in the early 2000s. Long-Term Capital Gains Tax A colleague recently said, “The capital gains tax is the most misunderstood tax in the IRS tax code.” We find the majority of property owners know the current capital gains tax rate but do not understand the intricacies of the calculation or the impact it has on a property

Cap Rate on Commercial Property Sales

Cap Rate on Commercial Property Sales All Property Types Combined

10%

9%

8%

U.S. Midwest

7%

6%

5%

2001

2004

2007

2010-f

Source: Real Capital Analytics, Grubb & Ellis

Table 1 Sale Price of Commercial Property:

$1,000,000

Deduct: Selling Expenses

(50,000)

Net Selling Price

$950,000

Original Cost or “Basis” Add: Capital Improvements

$ 500,000 200,000 (150,000)

Deduct: Accumulated Depreciation

Total Adjusted Basis NET GAIN ON SALE

($550,000) $ 400,000

25 Percent Tax Rate for Accumulated Depreciation 15 Percent Tax Rate for (Remaining) Capital Gain

$150,000 x 25 Percent = $37,500 $250,000 x 15 Percent = $37,500

TOTAL TAX LIABILITY

$75,000

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