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--- Commercial real estate professionals live and breathe capitalization rates.
Every trade publication, market participant, and third-party report relating to
real estate quotes cap rates for various markets and properties. But ask a
group of real estate professionals to calculate a specific property’s cap rate
and you are likely to get a variety of answers — despite the simplicity of the
formula. If cap rates are widely used and easily calculated, then why does
everyone come up with a different answer?
This
article looks at the underlying reasons for cap rates variations, ranging from
different uses by market participants to different methods of cap rate
extraction. While CCIMs are trained to extract cap rates in a certain way, not all
market professionals use the same criteria. Understanding how such variables
can affect the cap rate and the value of a property is just as important as
developing — and using — a consistent method of cap rate extraction.
Cap Rate Overview
A
cap rate in its simplest form is a return on an investment based on the
principle of anticipation. Value is the present worth of future benefits. A cap
rate attempts to quantify the risk profile of the future benefits. It is
calculated by using a non-complex formula, R=I/V, where I is the net operating
income and V is the value of the property. In more complex terms, a cap rate
measures a single-period, unleveraged rate of return on a real estate
investment. By converting income into value, a cap rate expresses the
relationship of one year’s income and value. A cap rate’s three main components
are net income, property value, and the rate of return. If two of the three
variables are known, the unknown variable can be extracted through a simple
calculation. Granted, different types of cap rates exist — overall, terminal,
equity, mortgage, building, and land — which may cause some confusion among
market participants. The overall rate, or OAR, is the cap rate applied to both
the land and building and is the most commonly used rate by real estate
professionals. A cap rate is essentially a dividend rate, so one could call the
mortgage constant a “lender” cap rate and a cash-on-cash an “equity” cap rate.
However, in commercial real estate transactions, brokers and investors tend to
focus on two cap rates: acquisition and disposition.
Marketplace Misuse?
Common
reasons for cap rate variations often come from the income stream and operating
expenses used in the rate’s extraction. Failure to consider the likely future
income of the property (year one pro forma) does not follow the principal of
anticipation. The historical and current operating data is useful when
developing a projection of year one data, but should not be used in the
extraction of a cap rate when applying it to year one projections. Extracting a
cap rate from market data using historical income and applying it to the year
one projection of the property being valued will result in an incorrect value
opinion.
Real
estate is often considered a hedge against inflation due to the ability to
increase rents at or above the rate of inflation. In an upward trending market
the buyer of a property is expecting next year’s income (year one) to be greater
than the trailing year to account for appreciation. Extracting a cap rate from
the in-place income (less risk) and applying it to the future income projection
(more risk) will overvalue the property.
In
addition, the same method of income and expense projections used to extract a
cap rate from the market should be used to value a property. Using a different
income stream from a comparable property (not stabilized, no third-party
management, no replacement reserves, under market operating expenses, and such)
will result in a different risk profile of the income stream and corresponding
cap rate.
Many
market participants do not include replacement reserves as an above-the-line (net
income) expense when developing cash flow projections. Replacement reserves for
future capital expenditures are market specific. Including or excluding
replacement reserves will have an impact on the cap rate extracted from the
sales transaction, but not the value of the property. Neither method is
incorrect as long as the same method is applied to the property being valued
and the sale comparable. If the sale comparable does not include replacement
reserves in its pro forma projection, and the subject does include replacement
reserves in its year one projection, the market extracted cap rate must be
adjusted downward to reflect a riskier income profile of the sales transaction
comp when compared to the asset being valued. If no adjustment to the cap rate
is made, then the subject will be undervalued due to differing risk profiles.
Properties that do not include replacement reserves have increased risk due to
the lack of a sinking fund for future capital expenditures. In other
words, the NOI needs to be “clean”: One cannot compare an NOI with deducted
reserves above the line with one deducted below the line.
Owner-Managed
Properties
Another
common misconception concerns third-party management fees. Small properties or
ownership entities that have a built-in management company often do not include
third-party management fees in their pro forma. Having a third-party management
company manage an asset may reduce the operational risk of the property and can
result in a lower risk profile of the future income stream. A lower risk
profile results in a lower cap rate. Table 1 shows how excluding third-party
management fees impact the year one return and risk profile.
As
Table 1 reveals, a 7.5 percent cap rate is appropriate if the property pro
forma includes expenses for third-party management fees. Based on the projected
NOI and market extracted cap rate, a value of $1,666,667 is indicated. If the
same property does not include management fees in the pro forma projection, the
value of the property is unchanged, with the risk adjusted cap rate increasing
to 8.1 percent.
This
is why it is necessary for potential buyers to reconstruct NOI to include such
items as property management. The increase in the cap rate is to account for
increased risk due to the lack of professional third-party management.
Additionally, real estate is considered to be a passive investment with the
opportunity cost of the owner’s time requiring compensation through a
management fee or higher rate of return.
Expense
Comparison in Sale Comparables
Comparing
the operating expenses used in a sale comparable to extract a cap rate is a
good indicator if the cap rate is market driven. A sale comparable that is
owner managed and does not include reserves will have below-market expenses on
a per unit comparison (percentage of effective gross income, per square foot,
per unit, and such). A comparison of the expenses from the sale comparables to
industry standards used in the local market will allow the analyst to adjust
the extracted cap rate accordingly and then apply the revised cap rate to the
property being valued. If a data set of comparable sales indicates a wide range
of cap rates, then it is likely that one or more of the sales is not based on
market derived income and expenses.
Impact on Property Valuation
Table
2 shows how various income and expense projections can impact the extracted cap
rate and the asset’s value indication. For purposes of this analysis, only one
variable has been adjusted. In actuality, a sale comparable will often have
multiple variables that need to be adjusted in order to accurately extract a
cap rate.
The
Table 2 example reports a market extracted cap rate that ranges from 5.70
percent, based on the asking price commonly quoted by brokers in third-party
surveys for marketing purposes, to 6.48 percent, based on using year one
projections. All of the extracted cap rates are correctly calculated. However,
the difference in rates is attributed to varying risk profiles of the income
stream. Based on the provided example, adjusting just one variable can result
in a 13.68 percent difference in value. If additional variables are included,
the spread between the cap rates can widen and further magnify the
miscalculation.
While
there is a simple formula for finding the cap rate, there is no standard method
for cap rate extraction. Various markets and market participants apply
different income and expenses projections when calculating NOI. However, a
standard method for extracting a cap rate from market data is critical to
properly value a property. Not all NOIs have the same risk profile. A property
that includes third-party management and replacement reserves will have less
net income, a lower risk profile due to adequate third-party management, and
appropriate funds for future capital expenditures — and result in a lower cap
rate. Regardless of the variables included or excluded in the cap rate
extraction, if applied consistently to the property being valued, a reliable
estimate of value will result.
The Cash Flow Analysis Worksheet
used in CCIM classes shows reserves below the NOI line, so CCIMs need to pay
careful attention to the components of NOI and make sure that the NOIs of
comparable properties are calculated in a consistent manner. A thoughtful CCIM
will re-construct NOI to be consistent and will know enough about cap rates in
the marketplace and expense ratios, vacancy, and market rents to sense if
adjustments are necessary to an advertised NOI.
For more reading please follow this link http://www.ccim.com/cire-magazine/articles/323788/2015/03/cap-rate-variations
