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What Determines the Cap Rate When Buying or Selling a Business?
A Capitalization Rate (Cap Rate) is the ratio between the Net Operating Income (NOI) of a business and its original cost, or alternatively, its fair market value. The NOI is the income before interest on any loan, depreciation expense, and income taxes.
The Market, through the forces of supply and demand determines market values and cap rates for various types of assets including businesses. Of course, the market is made up of many buyers (demand) and sellers (supply) at any one time who each participate in the overall market and who may pay or receive a higher or lower price or cap rate depending upon numerous factors. Some of these factors are objective while others are subjective. Buyers use market cap rates as a basis for comparison, but ultimately decide what is acceptable to them based on many factors including risk.
Following are numerous factors that are considered by buyers and sellers of businesses that effect the price they will pay or receive and the corresponding cap rate:
- Is the industry expanding or contracting and what are the future prospects of the industry?
- If the business location is important, is the location improving or declining?
- If the business location is important, is the lease for the premises advantages or disadvantages?
- If retail traffic is important, are any changes likely to occur that would materially effect the business location positively or negatively? For example, if you know that an anchor tenant in a shopping center (Nordstroms, Vons, etc.) was going to move out, would it make a difference in the price?
- Will the business provide high paying jobs for family members?
- How stable or volatile is the income of the business? Is the income likely to increase, decrease, or stay the same with a change of ownership?
- Do the business expenses include sufficient funds to pay the owners reasonable compensation for their work? Remember, return on the invested capital should be considered separately from compensation for work performed.
- Do the business expenses include a reasonable, realistic contingency factor?
- Does the buyer own an existing business that will benefit by the acquisition of the business? Will the acquisition generate cross-selling opportunities, cost savings, or other benefits? Will the acquisition eliminate a strong local competitor?
- Does the buyer believe he or she can increase the volume of business cost effectively?
- Is the business located conveniently for the buyer providing a life style advantage?
- Is the seller willing and able to provide attractive financing to the buyer?