Capitalization rates (cap rates) are used by buyers, sellers, bankers, property appraisers and even financial statement auditors as they evaluate the fair value of income-producing real estate properties. Buyers and sellers use cap rates while negotiating price. Bankers and their appraisers use cap rates in assessing fair value in lending transactions. Auditors also use cap rates in evaluating potential impairment and impairment charges to client financial statements.
But be weary of placing too much reliance on cap rates and the Direct Capitalization Method in evaluating real estate transactions—this valuation approach can produce a vast range of very different values! Under this approach, fair value or price is estimated by first determining the Net Operating Income (NOI) of the property and then dividing NOI by the cap rate.
In a buy-side transaction, the cap rate essentially represents the return the buyer is looking to earn on his investment. For example, if an income-producing property generates an NOI of $2 million, and the buyer believes a reasonable return based on the risk involved is 10%, he or she would make an offer of $20 million—pay $20 million and earn $2 million (i.e., a 10% return). Now obviously the seller and his broker will have their own ideas about what a reasonable cap rate is in determining price—and presumably, those ideas are based on other current sales of like-kind properties. From the seller’s perspective, the cap rate is merely a market-driven number derived by changing the variables to the basic equation noted above. Let’s say instead, average like-kind properties have been selling at twelve times their NOI. In this case, the market calculated cap rate is 8.3% (or one divided by 12), and the estimated sales price (using NOI from the example above of $2 million) is $24 million—sales price being determined by dividing NOI by the cap rate (a simple change in variables to the basic equation!).
But here is where the buyer, banker or auditor should take a step back and proceed as if approaching a yellow light of caution! The inputs to these calculations can produce big, big changes in the perceived value of the underlying real estate.
To start with, NOI is a slippery calculation because it’s based on estimates—specifically, estimated future revenues and estimated future operating costs. If a buyer overestimates rental revenue or underestimates operating costs, then the NOI calculation can be missed badly. Say in our example, the buyer is able to acquire the property for $20 million expecting a $2 million NOI over the next year and using a 10% cap rate. But the actual NOI over the next year turns out to be only $1.8 million – using that same 10% cap rate, the value based on actual NOI is only $18 million—a huge swing. Keep in mind the old saying that “Cash is King”—and never more so than when valuing real estate. NOI essentially represents the cash a property is expected to produce; buyers of income-producing properties must look closely at what the property has done in the past and consider the likelihood that the past is a fair measure of the future. That includes assessing if lease agreements will survive; if tenants or lessees will be creditworthy; if competition will drive down rental rates; and if operating costs that include utilities, maintenance, management fees and property taxes will escalate. That’s a lot of “ifs”! And all of this does not even consider necessary capital expenditures—that’s cash, too!
And then you get back to the cap rate! Academically speaking, cap rates are based on some rather complicated formulas using again, various data inputs. But if buyers stay true to considering the cap rate as a “risk rate,” then their investing decisions will generally be sound. If revenue streams are volatile and the cost environment is unsteady, then a buyer should bump his risk rate or the return he wants to make. Success should then be defined by making your expected return, which of course starts with having an expected return! The key is understanding how changes in cap rates, as with changes in NOI, can produce wildly different value estimates.
And even when buyers and sellers agree and a contract for sale has been signed, the road ahead may still not be clear. Banks and their appraisers have their own ideas about cap rates and NOI, which can change loan-to-value ratios and potentially hinder the ability to obtain financing. After that, banks deal with examiners who also assess the value of underlying real estate based on similar valuation principles and may criticize or classify loans that don’t provide sufficient collateral. And if examiners are not happy, then the bank is not happy and well, ultimately all that unhappiness may trickle down to the borrower. Even your own auditor, if you have company prepared financial statements, may press you on the value of your real estate assets, if their calculations of fair value are lower than the value recorded on the books. So the road is long and continues through the time the property is sold again.
The smarter buyers and sellers understand the challenges cap rates in particular bring to closing transactions—it’s always best to be armed with good and current information. In Florida, the University of Florida Bergstrom Center for Real Estate Studies prepares a comprehensive survey (generally annually) of emerging market conditions, including trends in cap rates on various income producing properties. Read the Q1 2015 report here.