I get asked frequently what capitalization (CAP) rate is appropriate
for downtown Aspen investment properties in the current recessionary
environment and credit crisis. To answer this question, we have to
examine what the CAP rate represents in the world of investment real
estate.

The CAP rate is the net operating income (NOI) divided by the price of
the investment. The NOI is the net income the property returns to the
owner after operation expenses. Most commercial leases in downtown
Aspen are net of expenses i.e. the tenants pay the building's operating
expenses (CAM), real estate taxes, insurance and property management
costs. Assuming no substantial vacancy, the total amount the building
tenants in base rent should approximate the building's NOI.

The initial CAP rate an investor is willing to pay for an investment
property is related to the investor's view of what the building will
likely produce in future cash flow and the probability of receiving
that cash flow i.e. risk. The higher the investor's expectation of
future NOI and her confidence in the certainty of actually receiving
the cash flow, the lower the CAP rate the investor will pay for the
investment. The lower the investor's expectation of future NOI and the
higher the risk of receiving the future cash flow, the higher the CAP
rate the investor will demand.

The initial CAP rate can also vary depending on whether the investor
sees opportunity to increase the properties cash flow through means
other then the normal change in market rents. For the purposes of this
discussion, we're going to assume the property is retail and does not
have any unusual opportunity to increase cash flow other then general
increase in market rents.

Over the past 12 years, CAP rates on the sale of retail properties have
ranged from 100 to 450 basis points over the 10-year Treasury bill (see
graph) which presently yields 3.98 percent. Currently, the national
average CAP rate for retail properties is 6.8% as reported by
Commercial Real Estate Outlook.

If you assume that investment capital will seek investments offering
the best return for the same risk, investors should be willing to
purchase investment properties in Aspen at a lower CAP rate than the
national average primarily for two reasons: 1) the retail vacancy rate
in downtown Aspen has historically been under 1 percent versus the
national average of around 7.5 percent or greater; and 2) Aspen's
historically low retail vacancy rate. The market retail rents in Aspen
have appreciated on average about 7.5 percent per year over the past
thirty years, versus about 3.0% for the national average. For these
reasons, investors should be willing to pay higher prices (i.e. lower
CAP rates) for Aspen investment properties. Historically this has been
the case.

So what's a reasonable CAP rate for investment properties in downtown
Aspen considering the national economy and credit crisis? To answer
this question, I created a 10-year present value cash flow model to
compare the returns on a typical Aspen property investment with a
hypothetical investment in a retail property representing the current
national averages for vacancy rates and market rents.

Using similar acquisition financing (i.e. 6.0% interest rate, 1:25 debt
coverage ratio, and 30 year amortization, a loan, but for the credit
crisis, should be available), I determined that an investors could
purchase a property in Aspen at a 4.9 percent CAP rate (approximately
100 basis points over the current 10-year treasury bill rate) and
realize approximately the same internal rate of return over 10 years as
an investor purchasing a retail investment property in another part of
the country at a 6.8 percent CAP rate for the same timer period. This
is roughly 190 basis points less than the national average CAP rate for
retail property investments and 100 basis points over the 10-year
Treasury bill rate.

Although each investment is influenced by a number of factors such as
tenant mix, lease terms, age and condition of property, lease rental
rates versus market rental rates and opportunities to add value, this
analysis would indicate in basic terms an Aspen downtown property
investment should demand a CAP rate up to 190-200 basis points below
the national average and about 100 basis points over the 10-year
treasury bill rate due primarily to the low vacancy rate and the higher
then average annual appreciation in rental rates in downtown Aspen.

William Small is managing director of Frias Commercial Real Estate
in Aspen. He has over 23 years of experience in all aspects of
commercial-investment real estate from major cities as Washington,
D.C., and Denver to smaller resort communities. He can be reached at
Bill@friasproperties.com.