Which revenue stream should you use to compute the capitalization rate? Obviously the seller (owner) will use the lease rate. After all, those numbers are the real ones. Many buyers (particularly those using other people’s money) will accept the revenue stream provided by the terms of the leases, subject of course to a review of the leases. Potential buyers need to be aware of any differences between the market rent and the lease rent. Why? Because when the lease(s) expire, they will be renegotiated (remember that lessees are not stupid) at the market rate. When this happens, two components change: (1) The cash flow is lowered, and (2) any new potential buyers will be looking at a significantly lower revenue stream.

Lower income means a lower NOI. Changes in the dollar amounts of the NOI are not reflected in a dollar-for-dollar change in the value assigned to the real estate. A change in each dollar of the NOI has a multiplying effect on the value of the real estate. For example, when you use a 6.5% capitalization rate, each dollar change in the NOI has an impact on the value of the real estate of $15.39, or more than 15 times any change in the NOI.

The following chart illustrates the dramatic change in property value when the market rate rent changes.

Assumptions

Building: 25,000 net rentable square feet
Time Period: 5 years
Income: $1 per square foot the first year declining .05¢ each subsequent year
Operating Expenses: 25% of income the first year and remaining constant for the next four years
Capitalization Rate: 6.5%

During this five-year period the annual NOI decreased from $225,000 to $165,000. At the same time, the market value of the property declined from $3,461,539 to $2,538,462. This significant loss of value happened using very conservative assumptions. (1) Operating expenses did not increase during the five year period. Not likely. (2) The cap rate remained at 6.5%. Given the condition that promulgated lower revenue, it is more than likely the cap rate would have increased.

Using market rates for revenue instead of lease rates may not be good news for the managers of many income-producing portfolios. The fact is that when you use the current marketplace to determine revenue instead of using leases that will expire in the near future, you can’t lose. You can’t lose value that didn’t exist.

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