A 5.5% cap means the buyer paid $1.43 million for an income stream of $78,500. The income stream is referred to as the Net Operating Income (NOI), which is essentially income (rent Dunkin Donuts pays the property owner) minus the expenses to operate the building. It does not include mortgage payments.
The building is in a great spot for a Dunkin Donuts, located on the "breakfast" side of the street (the side of the street traffic moves on the way to work in the morning). The drive through is routinely so busy there is a line to enter from the main road.
I would imagine this will continue to be a great business for many years into the future (Dunkin Donuts currently has a lease in place through 2024). However, will the buyer of the building ultimately make money on the property?
As with almost any investment around the world, purchasing this building today is a bet on the future direction of interest rates. Investors are searching for yield and they have moved out on the risk spectrum in order to try and find a return. Purchasing a commercial building involves many potential risks, some of which are:
- The individual owner of the Dunkin Donuts store could get into financial trouble and be forced to sell.
- One or more competing breakfast stores could open up along the same route to try and capture some of the morning market share.
- The building could catch on fire or flood.
You must also weigh the fact that there is additional work involved with purchasing a building vs. buying a stock or bond where you simply collect your dividend or interest payment every month. The owner of this building (which most likely has a professional management company in place) must take the time to monitor the management company. The owner is a 1031 exchange investor from California.
When you purchase a property today you must think about what investments you will be competing with in the future when the time comes to sell or refinance. Commercial real estate is usually financed under 10 year terms, so the most obvious competitor would be a 10 year treasury bond (the risk free investment). What if 5 years from now the 10 year treasury bond has risen from its current yield of 2.5% to 5.5%?
No one is going to purchase a commercial building with the risks just discussed at a 5.5% cap rate if they can receive that same 5.5% return from a risk free bond that requires no management. That means the cap rate on the commercial building would need to rise to provide a spread large enough to attract investors in the open market. Let's say that spread remains at 3% and the cap rate rises to 8.5%.
What is the building worth at an 8.5% cap rate with an income stream of $78,650?
$925,294 or $504,706 less than what was paid for the building. This scenario assumes that no problems occur with the building or the Dunkin Donuts operating within it; only that interest rates more toward a more rational level. It also does not include the cash flow made on the property during the years before the sale. If the buyer paid cash for the building and received $78,650 per year, then the loss would fall to only $111,456. When you include cash flow, however, you are not considering the opportunity cost of where the money could have been invested if it was not put toward buying the building.
This is just one example of the losses coming in the future for those that are reaching for yield today. The commercial property market does not exist in a vacuum. A rise in rates will lead to many areas of the current artificial economy shrinking or shutting down. This will lead to layoffs, which will lead to a loss in discretionary spending. Will someone stop at Dunkin Donuts to pay $5 in the morning for coffee and donuts if they are struggling to pay their power bill? What would an investor be willing to pay for the commercial building if the business viability of its tenant were called into question?
If you can begin to move your mind through a thought experiment like this you can put yourself into a future world and work backwards to understand how to profit from its arrival.