Definition of Capitalization of earnings:
The general concept of capitalization of earnings is a method of determining the value of an organization by calculating the net present value (NPV) of expected future profits or cash flow. The capitalization of earnings estimate is determined by taking the entity’s projected annual earnings and dividing them by the capitalization rate (Cap Rate). The net income divided by the Cap Rate will reflect the expected value of the business. Also stated (NOI/Cap Rate = Value).
When investing in real estate or getting a loan, understanding the use of capitalization approach (Cap Rates) in the valuation process is critical. This subject is important to commercial realtors, lenders, developers, and investors in income-producing real property.
Definition of Capitalization Rate (Cap Rate) in real estate:
Cap Rates represent the ratio of annual Net Operating Income (NOI) to the property asset value (NOI/Cap Rate= Value). The market value will be the same whether the property has debt or is debt free. The market income capitalization approach only calculates net operating income as if the property was debt free. (NOI) is projected market rents, less a vacancy allowance and collection loss, less operating expenses. If you have properties with similar characteristics in a close geographical location that have sold in an arm’s length cash transactions, and the income stream data is available, you can calculate the comparison Cap Rates.
Note the difference between market rent and actual rent in the Cap Rate valuation process. Compare 2 different buildings, both identical, but the first property is well kept and rented at a market rate and a second building has deferred maintenance and is under-rented by 30%. In both cases you would use market rents to determine the (NOI). The assumption about the second building is that a new owner would fix up the building and adjust the rents upward to market. The value of the second building would be adjusted downward as the cost to cure. The only time that you would use the lower rent is in the case of lower rates locked into long-term leases or rent controlled properties.
Creating a historical property rents database gives the total calculation value. Historical market Cap Rates may vary, even in the same geographic location, depending upon the building improvements, effective age, class of construction, off street parking, furnished or unfurnished, condition, compliance with zoning, and amenities. Examples include Class A vs Class C office, industrial, apartments, new modern styles with amenities vs older dated properties. The strength of the tenancy from national credit with long-term leases vs mom and pops’ month to month would cause a different Cap Rate. Most likely the mom and pop tenancy would reflect a higher Cap Rate interpreted as riskier. The higher the market Cap Rate the higher the perceived risk. The lower the market Cap Rate the lower the perceived risk. An exception would be where the national credit tenant locks in a lease/rental rate that does not increase as the market dictates or anticipates, reflecting below market rent. The mom and pop could be converted to a market rent, by either gaining a new tenant or by renegotiating the rent with a higher level.
Market rents should be used rather than actual rents when applying the market Cap Rate to the subject property. Market rents are obtained by surveying the local market to create comparable rents.
In many cases, actual rents are lower or higher than the market would dictate. When there is a lease-up period, such as with new construction of an income-producing property, future cash flows need to be estimated to the point of income stabilization, then the future stabilized income is discounted, using an estimate of a capitalization rate, and a discount rate. Once the market Cap Rate has been determined, you can apply it to the NOI and Cap Rate analysis of the property under consideration to show the probable market value.
Work with a competent commercial appraiser, who can assist and calculate the correct market Cap Rate. Do not try to do this yourself without the help of an appraiser who has knowledge of the type of real estate and local market.
Below is an example: The market Cap Rate for a commercial property with triple net leases (NNN) has been determined to be 6.5%. Triple Net or (NNN) refers to property that are leased or rented where the tenant pays all expenses related to the operation such as taxes, insurance, maintenance and occasional capital improvements. The 10,000 square foot multi-tenant property under consideration generates monthly rents of $1.50 per foot. On a (NNN) example for a Cap Rate analysis, one would apply a 10% vacancy collection and loss factor and expenses of 5% for non-charge backs to the tenants for management and reserves, the NOI is $153,900.
The NOI and Market Cap Rate are known so you can calculate the value:
10,000 SF X $1.50 = $15,000 Per mo. X 12 Mos. = $180,000 = potential gross income.
$180,000–$18,000 for 10% vacancy = $162,000–$8,100 for 5% expenses = NOI = $153,900
$153,900 NOI /.065 Cap Rate = value = $2,367,692
From an investment standpoint market Cap Rates can show a prevailing rate of return at a time before debt service. This will assist a lender and investor to measure both return on invested capital and profitability based on cash flow. An informed lender or investor should understand that there may be dramatic variations in a property’s value when unsupported or unrealistic Cap Rates are applied.
Cap Rates may move up or down depending on the condition of the market and the demand for income-producing properties. The term Cap Rate compression reflects a movement of the rate downward because investors perceive real estate as lower-risk, higher reward asset class relative to other investment options. Cap Rate decompression may result from a reduced demand for real estate purchases where cap rates move upward reflecting downward valuations. This may be a byproduct of higher interest rates or government intervention such as rent control.
Why do we use Cap Rates?
The capitalization approach is a “comparative method” of valuing property based on similar geographic locations, similar properties and similar risks that would yield a comparable rate of return. Once the value is established, the comparative method can calculate the loan to value to determine if property value falls within the lenders loan underwriting guidelines.
Cap Rates are only one metric. It represents a snapshot of the market at the time of investment and does not take debt service or financing costs into consideration. Therefore, if a borrower will finance his investment, as most people do, then further analysis such as cash on cash return would be useful. Sophisticated loan underwriters and investors may also calculate an Internal Rate of Return. These calculations assist in establishing that the property is not only income-producing but a worthwhile investment.
Market rents may be determined in by a rent survey. Market rents may or may not be the same as actual rents. There are many instances where the actual rents will be above or below the market. A long-term lease may lock in lower rents. For example, I once underwrote an industrial building near San Francisco that was about 100 years old. The property has a long-term lease of 18 cents per square foot, while the current market was 1 dollar a square foot. Since the market rents were much higher the valuation metric used was based upon the lower locked in rental rate. An actual rent may also be higher than the market. A property owner may own the property in one title method and occupy all or a portion of the building in another title method. He may charge above or below market rents to himself for tax purposes. In this case the appraiser will use market rather than actual rents to determine the Cap Rate.
There are other instances where a conventional comparative market Cap Rate analysis is not appropriate. The alternative method is called a discounted cash flow analysis such as original ground up construction where the building cost and the cash flow from a lease up needs to be projected over a reasonable time period. This is done by a competent appraiser who can construct a model estimating a future projected cash flow and using net present value discount formulas to estimate the capitalization rate. The result may differ from the market comparison method.
Cash on Cash Return
Cash on cash return is a quick analysis that can be done to determine the yield on an initial investment. The cash on cash return is developed by dividing the total cash invested (the down payment plus initial cost), or the net equity into the annual pre-tax net cash flow.
Assume the borrower purchased the property which costs $1,200,000 and provides an NOI of $100,000, with a $400,000 down payment representing the equity investment in the project. The cash on cash return for this property would be:
$100,000 / $400,000 = 25% = cash on cash yield.
If the borrower were to purchase the property for all cash, as contemplated in a Cap Rate calculation, then the cash on cash return would be:
$100,000 / $1,200,000 = 8% (this example the 8% is both the cash on cash yield and Cap Rate).
It is clear from this formula that leveraging or financing real estate transactions will yield a higher cash on cash return, provided the transaction is financed at a favorable interest rate.
Internal Rate of Return
The internal rate of return (IRR) refers to the yield that is earned or expected to be earned for a capital investment over the period of ownership. IRR for an investment is the yield rate that equates the present value of the future benefits of the investment to the amount of capital invested. IRR applies to all expected benefits, initial down payment plus cost, including monthly and yearly cash flow and the proceeds from resale at the termination of the investment. IRR is used to measure the return on any capital investment before or after income taxes. Ideally, the IRR should exceed the cost of capital.
Is there an ideal Cap Rate?
Each investor should determine their own risk tolerance that will reflect the ideal risk reward level for their portfolio. A lower Cap Rate means a higher property value. A lower Cap Rate would mean that the underlying property is more valuable, but it may take longer to recapture the investment. If investing for the long-term one might select properties with lower Cap Rates. If investing for cash flow, look for a property with a higher Cap Rate. Declining Cap Rates may mean that the market for your property type is heating up and demand is intensifying. For Cap Rates to remain constant on any investment, the rate of asset appreciation and the increase of NOI it produces will occur in tandem and at the same rate.
Below are examples of the effect changes in NOI and/or Cap Rates on asset values:
As NOI increases and Cap Rates remain the same, asset value increases.
NOI CAP RATE ASSET VALUE
$300,000 /.06 = $5,000,000
$350,000 /.06 = $5,833,000
$400,000 /.06 = $6,666,666
$450,000 /.06 = $7,500,000
The effect on Asset Value when the Cap Rate varies.
NOI CAP RATE ASSET VALUE
$500,000 /.03 = $10,000,000
$500,000 /.04 = $ 8,333,333
$500,000 /.05 = $ 7,142,857
$500,000 /.06 = $ 6,250,000
Correlation Between Cap Rates and US Treasuries
The US Ten Year Treasury Note (UST) is deemed to be the risk-free investment against which returns on other types of investments can be measured. Interest rates on UST have been on a broad decline for many years but have risen. As interest rates rise, Cap Rates will rise and consequently there may be a reduction in asset values over time. With so many uncertainties in the market, and growth projections constantly being revised, the spread between UST and Cap Rates have not remained constant.
The effect of cap rates moving up or down resulting from artificially low interest rates, inflationary expectations, and anticipated increased interest rates need to be discussed in another article.
Property appreciation from excess demand, perhaps one of the greatest reasons for investing in real estate, is not part of the Cap Rate calculation. For investors, the tax benefits of owning commercial real estate may, in and of themselves, be the driving force to make such an investment. If the property is to be leveraged, then there may be write-offs for loan fees, interest expense, operating expenses depreciation and capital expenses.
As interest rates go up resulting in higher cost to debt service, this will cause Cap Rates to rise, and values to go down? Not in the short term, but yes in the intermediate and long-term. Remember that increased debt service based upon higher interest rates is not considered in the capitalization approach. Over time as interest rates go up, property owners will feel the sting of higher debt service payments. Some contemplated property transactions may become less appealing financially. As purchasers and borrowers decide not to purchase, this may compound and create more unsold inventory. Some sellers may get desperate and reduce price to sell quicker. The lowered price would cause an increased Cap Rate. On a macro level, this could cause lowering all real estate prices.
How dramatic can lower real estate prices be over time? As we witnessed 10 years ago that the contagion effect could spread and result in lower values and increased Capitalization Rates.
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