Summary:

The capitalization approach, a fundamental method in property valuation, estimates the fair value of an asset, such as income-producing real estate or a business, by calculating the net present value (NPV) of expected future net profits and net cash flow, referred to as Net Operating Income. This method, commonly known as the income approach, is a vital tool in the real estate industry.

Article:

Understanding the income capitalization approach (Cap Rates) in property valuation is not just a theoretical exercise. It's a practical necessity when investing in income-producing real estate or obtaining a loan. This knowledge is not just useful; it's essential for commercial realtors, lenders, developers, and investors in income-producing real property, equipping them with the tools to make informed decisions in their day-to-day professional roles.

Net income divided by the capitalization rate will reflect the expected value of the income-producing asset. Re-stated: Net operating Income divided by the capitalization rate = value (NOI/Cap Rate = Value).

Example: Property Income and Expense Statement Format

The calculation to arrive at the Net Operating Income

Potential gross income$ XXXX

Contract rents (tenant occupied spaces) XXXX

Escalation income XXXX

Market rent * XXXX

Other income XXXX

Total potential gross income(PGI) $ XXXX

Vacancy and collection loss & rental concessions (V&C) - XXXX

Effective gross income(EGI) = $ XXXX

Operating expenses

Fixed $ XXXX

Variable XXXX

Replacement allowance XXXX

Total operating expenses(OE) = - XXXX

Net Operating Income(NOI) ** XXXX

Total annual debt service(ADS) - XXXX

Pre-tax cash flow(PTCF) $ XXXX

*Market rents should be used for rents attributed to vacant space, lease renewals, and owner-occupied space:

** Depreciation, capital expenses, and loan costs are not considered in the calculation of the NOI

As stated again, The capitalization Rate represents the annual Net Operating Income (NOI) divided by the cap rate to derive the property asset value (NOI/Cap Rate Value).

Why use Capitalization Rates?

The capitalization approach is a comparative method of valuing properties with similar properties, income streams, geographic locations, and risks that will yield a comparable rate of return. Once the value is established, the comparative method can calculate the loan-to-value to determine if the property value falls within the lender's loan underwriting guidelines.

The capitalization approach is calculated as if the property is debt-free. The value will be the same whether the property has leveraged debt or is debt-free. It represents a market valuation snapshot of the investment and does not consider loan debt service payments or financing costs. The cap rate method is only one metric.

If investors finance their acquisition, as most do, further analysis, such as cash-on-cash return, will be helpful. Sophisticated investors and loan underwriters may also calculate an Internal Rate of Return. These calculations assist in establishing that the property is income-producing and a worthwhile investment.

A licensed commercial appraiser may perform a rent survey to determine market rents for a property type in a geographic area. Market rents, which may or may not be the same as actual rents (contract rents), play a crucial role in the valuation process. Understanding these concepts is not just important, it's critical and makes the audience feel more informed and aware of their significance in the valuation process.

I once underwrote a loan transaction on a 100-year-old industrial building near San Francisco. The property has a long-term lease of 18 cents per square foot, while the current market rent was $1.75 a square foot. Since current market rents were much higher, the valuation metric was based on calculating the net operating income using the locked-in lower rental rate. The property value reflected a much lower result than the exact property using current market rates.

A property owner may own a property using one title method, such as The Archie Bunker Corporation, and occupy all or a portion of the building using a different title method, such as Archie Bunker Limited Liability Company. He may charge himself above- or below-market rents for tax purposes. Actual rents may also be higher than the market. In this case, the appraiser would use market rents rather than actual rents to determine the Cap Rate.

There are other instances where a capitalization approach is inappropriate. For example, in the case of original ground-up construction, the alternative method is a discounted cash flow analysis. The building cost and the cash flow from a lease-up will be projected over a reasonable time to the point of stabilized occupancy. 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. Understanding these instances is crucial for comprehensively understanding the valuation process, making the audience feel more knowledgeable and prepared.

Suppose you have income properties with similar characteristics in a geographically close location sold in arm's length cash transactions, and the income stream data is available. In that case, web-based databases track comparison capitalization rates (Cap Rates).

Market rents are the amount that can be expected for a property compared to similar properties in the same geographic area. Contract rent, or actual current rent, is what the same units are being rented for today. Understanding this crucial difference is not just important, it's essential for accurate property valuations and can make the audience feel more knowledgeable and prepared for the valuation process.

There is an essential difference between market rents and current actual(contract) rents in the Cap Rate valuation process. Compare two different buildings, both identical, but the first property is well-kept and rented at a market rate, and the second building has deferred maintenance. 'Deferred maintenance' refers to the necessary repairs and maintenance that have been postponed, which can significantly affect the property's value. The property with deferred maintenance is rented at under-market rates of under 30%. In both cases, a lender and the appraiser will use market rents to determine the (NOI). The assumption about the second building is that a new owner will upgrade the building and adjust the rents upward to a market rate. The value of the second building would be adjusted downward or discounted to offset the cost to cure (cost to upgrade the building).

The only time that a lender or appraiser would use the lower rents was when those rates were locked into a long-term lease or a rent-controlled property. 'Locked-in rents' refer to fixed rental rates for a specific period, often due to a long-term lease agreement or rent control regulations. For instance, I once underwrote a prospective loan for an industrial building in Richmond, California. The property was leased for a fee and leased out to a third party for 99 years, with 50 years remaining. The locked-in rent was only 18 cents per square foot triple net. The property owner and broker argued belligerently that the current value should be based on today's rent, which was a much higher rate.

An inconvenient fact in this example is that the property owner is locked into an 18-cent-per-square-foot monthly income stream for the next 50 years. Capitalized rents will be based upon an 18-cent-per-square-foot lease rate. The capitalized value with an 18-cent-per-square-foot lease rate will have a dramatically lower NOI compared to a similar building next door that rents at a monthly $1.75-per-square-foot lease rate.

Many historic rent comparison databases are available to determine market rents to calculate a correct capitalized valuation. Historic market Cap rates may vary, even in the exact geographic location, depending upon the building improvements, effective age, class of construction, off-street parking, furnished or unfurnished, condition, compliance with zoning, easements or lack of needed easements, and amenities. Examples include Class-A vs. Class-C offices, industrial apartments, older, dated, economically obsolete, and under-parked compared to a new modern building with adequate parking and currently popular amenities.

Capitalization approach to value: Advantages and disadvantages.

Advantages:

• This method converts an income stream into an estimate of the value of the income-producing real estate.
• The method is a typical appraisal, lending, and development standard.
• < UNK> The income capitalization approach is common in evaluating commercial income-generating properties, but it can be applied to any income stream, including businesses.
• Commercial appraisers are a reliable source for determining market cap rates.
• Commercial realtors provide an excellent source of cap rates with websites such as Costar and Crexi
• There are online databases such as the CBRE/US-Cap-Rate-Survey-Special-Report to obtain reliable data.

Disadvantages:

• The method is used for comparison only with similar properties in a close geographic area. The process does not consider liens on the property and debt service. A cap rate calculation is done as though the property is debt-free. Cap rates cannot be used to calculate overall net cash flow or cash-on-cash yield when a loan is attached to the property (Income, fewer operating expenses, less debt service).
• The results of a cap rate calculation are specific only to a similar area with similar properties in certain market segments. You could not use Newport Beach, California, cap rates to compare with an identical building with similar usage in Little Rock, Arkansas. Also, the demand for properties and cap rates for different real estate market segments changed. Current examples are residential income properties and industrial properties, which are and will continue to be in demand. I read one estimate that industries in the U.S . will require an extra billion square feet of warehouses by 2025. Office and lodging/resort-related properties are not so well. Patterns change!
• The method contemplates stable economic market conditions. If a market experiences a significant downturn, collapses, or is subject to extreme political uncertainty, the market cap rate calculations may be rendered irrelevant.
• Relying on a cap rate with an unstable market condition is difficult. Using market rents may become suspect because of higher foreclosure rates, tenants defaulting much more frequently, vacancy rates increasing, and replacement tenants asking for higher rent concessions, bringing the market rents down. Additionally, owner operating expenses may fluctuate.
• Calculating and forecasting future income streams involves high subjective judgment and is variable.
• Professional judgment is subject to subjective vs. objective interpretations about expectations of future benefits.
• The method may result in miscalculations when estimating the cost of capital outlay for upgrades to bring the property up to current standards. All job subsets have a price, time, and frustration allocation, including government regulatory intervention, state-level and municipal approvals, building reconstruction, modern materials, safety, zoning, environmental, and imposed social equity requirements.
• A complex analysis is required for property amenities, parking, easements, recorded encumbrances, and building and zoning regulations compliance.
• The lease-up period is only an estimate and may not be correct.
• Alleged appraiser and lender biases for racially segregated neighborhoods have been known to exist.
• Tenancies: landlords and tenants may enter into four types of rental or lease agreements. The type depends upon the agreed-upon terms and conditions of the tenancy. All rental amounts and terms of a lease will be reflected in the capitalization evaluation.

Types include:

• A fixed-term tenancy is a tenancy with a rental agreement that ends on a specific date. Fixed terms have a start date and an ending date. According to the written lease document, terms such as ten years with multiple extensions may be short or long.
• A landlord cannot raise rents or change lease terms because the terms are codified in a written agreement. A key advantage for a landlord is receiving today's market rents. A key for a tenant is locking in a long-term lease where the rents are or become below market over time.

A tenant company's net profits may be enhanced by paying substantial under-market rents based on a long-term lease. On the other hand, if a tenant company makes a good profit with rents substantially below market and a lease is coming due soon, the increased or negotiated upward lease rate may wipe out some or all the profits.

• A periodic tenancy has a set ending date. The term automatically renews into successive periods until the tenant notifies the landlord that he wants to end the tenancy. Month-to-month tenancies are the most common.
• The strength of the tenancies from national credit with long-term leases and corporate guarantees down to mom-and-pop month-to-month tenancies will result in a substantially different Capitalization Rate. National credit tenants with corporate guarantees have a considerably lower cap rate. Mom-and-pop tenancies will reflect a higher cap rate because they inherently have more risk.

The lower the market Cap Rate, the lower the perceived risks of property ownership. The higher the market Cap Rate, the higher the perceived risks. An exception would be where the national credit tenant locks in a lease rate that does not increase as the market dictates or anticipates increases. Eventually, over time, this tenant will reflect below-market rents.

A mom-and-pop tenant could be converted to a market rent quicker because the term is usually shorter.

Market rents are obtained by surveying local brokers and appraisal databases of local market rents.

• Tenancy-at-sufferance(or holdover tenancy). This form of tenancy is created when a tenant wrongfully holds over past the end of the tenancy period.
• I bring up this type of tenancy because of the manufactured COVID-19 fiasco. The government allowed tenants to skip out and default on paying rent without consequence. The tenants either defaulted on the rent or overstayed the term. Either way, the tenant becomes delinquent, and the owner attempts to evict them. The tenant or affiliates may become illegal trespassers.
• There are many examples of a landlord attempting to get rid of an illegal tenant only to be jerked around through the court system, with multiple appeals requested by the tenant. Stalling tactics were usually granted. Then comes various bankruptcies, not only of each tenant, one by one, but unknown parties who supposedly moved in without notice to the landlord. Then came the transients and fictitious folks who declared that they were a tenant and requested that the process start all over because of their fraudulently claimed tenancy. The courts, particularly in states like California, turn their backs on this behavior.
• The property owner's focus becomes using legal avenues to evict the tenants and regain property occupancy. This process has significant costs and frustration.
• Tenancy-at-Will. This form of tenancy reflects an informal agreement between the tenant and landlord. The landlord gives permission, but the period of occupancy is unspecified. The term will continue until one of the parties gives notice.

Property Rehabilitation and New Construction:

Establishing market rents becomes essential in underwriting a rehabbed or new building. When there is an extended lease-up period delay, such as with the 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 will be discounted using an estimate of a market capitalization rate and a discount rate formula.

Please work with a competent commercial appraiser to help calculate the right market Cap Rate. Please don't try to do this yourself without an appraiser who knows 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 (NNN) refers to a leased or rented property 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 5% for non-chargeable expenses tenants usually do not pay including reserves. The NOI would be $153,900.

The NOI and Market Cap Rate are known, so you can calculate the value:

10,000 SF rentable 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% non-chargeable expenses to the tenants = 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. The cap rate procedure will assist a lender and investor in measuring returns 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 and demand for income-producing properties will increase or decrease depending on market conditions. Cap Rate compression reflects a movement of the rate down because investors perceive real estate as a lower-risk, higher-reward asset class relative to other investment options. Cap Rate decompression may result from demand for real estate purchases where cap rates increase, reflecting lower valuations. This may be a byproduct of higher interest rates or government intervention such as rent control.

Loan-To-Value Ratio (LTV):

Review:

• The ratio between a mortgage lien(s) and the property's value pledged as security for the loan is usually expressed as a percentage (%).
• Loan divided by Value = Loan to value = $500,000 = 33.33% $1,500,000
• The loan expressed as a percentage of the value = 33.33%
• Use the relationships to find the unknown constant.
• To find the LTV, divide the loan by Value = LTV.
• To find the Loan: LTV x Value = Loan

To find the Value Loan divided by LTV= Value

• Cash-on-Cash Return:

Cash-on-cash returns are a quick analysis to determine the yield of an initial investment outlay. They are 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% (in this example, the 8% is the cash-on-cash yield and Cap Rate).

This formula shows that leveraging or financing real estate transactions will yield a higher cash-on-cash return, provided the transaction is funded at a favorable interest rate.

Internal Rate of Return (IRR):

Internal rate of return (IRR) refers to the yield earned or expected to be earned for an investment throughout ownership. IRR for an investment is the yield rate that equates the present value of the capital outlay and future dollar benefits to the amount of money invested. IRR applies to all dollar benefits, including the outlay of the initial down payment plus cost, the positive monthly and yearly net cash flow, and positive net proceeds from a sale at the termination of the investment. IRR measures 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 risk tolerance to reflect their portfolio's ideal risk-reward level. A lower Cap Rate means a higher property value. A lower Cap Rate would imply that the underlying property is more valuable but may take longer to recapture the investment. If investing 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.

NOI, Cap rates, and Value

Below are examples of changes in NOI and Cap Rates that cause asset values to rise or decrease:

Asset values will increase as NOI increases and Cap Rates remain the same.

(Rising NOI-net operating income and .06 reflects a 6% cap rate)

$300,000 /.06 = $5,000,000

$350,000 /.06 = $5,833,000

$400,000 /.06 = $6,666,666

$450,000 /.06 = $7,500,000

As NOI remains the same and cap rates rise, asset value will go down:

($500,000 reflects net operating income, and .03 reflects a 3% cap rate)

$500,000 /.03 = $16,666,666

$500,000 /.04 = $12,500,000

$500,000 /.05 = $10,000,000

$500,000 /.06 = $8,333,333

Correlation Between Cap Rates and US Treasuries:

The US ten-year Treasury Note (UST) is deemed a risk-free investment against which returns on other types of investments can be measured. As interest rates increase, those investors who bought USTs at a lower rate will find that their bonds will go down in value. Bonds purchased at the new higher rates will be in high demand.

As interest rates rise, cap rates increase, and asset value decreases over time. With so many uncertainties in the market and growth projections constantly being revised, the spread between UST and Cap Rates has not remained constant.

When the government intrudes into market forces, the results become artificial. This has caused capitalization rates to go down, reflecting higher values. Near-zero interest rates have also caused a dramatic inflationary spike in all goods and services.

Conclusion:

Property appreciation from excess demand has been one of the most significant reasons for investing in real estate. Appreciation is not part of the Cap Rate calculation. For investors, lower interest rates and the tax benefits of owning commercial real estate may be the driving force behind such an investment. If the property is to be leveraged, there may be write-offs for loan fees, interest, operating, depreciation, and capital expenses.

As interest rates have been forced down to meager rates, below inflation, by government mandate! Refinancing at lower rates has resulted in lower debt service payments. Cash flows of income-producing properties have increased, reflecting a higher net operating income.

The government intentionally creates market distortions that benefit the insiders at the top of the economic spectrum. The results are artificial. This has caused capitalization rates to go down, reflecting higher values. Near-zero interest rates have also caused a dramatic inflationary spike in all goods and services. All asset classes have now been spiked with 200-proof illusions that make everything seem fantastic on the surface. But hangovers the day after the party ends are no fun.

Interest rates have more than doubled, shattering the punch bowl into fragments. Continued interest increases will cause the economy to collapse overnight. Main Street and small capitalist entrepreneurs will bear the brunt of widespread financial damage.

Interest rates are increasing because the government realizes that inflation will only accelerate if it does not stop or slow down. Increased interest rates will result in newly originated loans having higher payment structures. Higher loan payments indirectly and over time cause cap rates to rise and values to decrease.

Values may not go down immediately, but the demand to purchase income-producing properties will subside because ownership makes less economic sense. To add flames to this fire, the federal and state governments pass legislation that will destroy investors' motivation to own.

Over time, the four-pronged whammy will become apparent.

• Rising interest rates,
• Increase in interest rates reflecting larger loan payments,
• General loss of investor confidence in the overall economy,
• Loss of investor interest in purchasing an income property,
• Overburdening & abusive government intervention in property ownership will come home to haunt the entire real estate market across the United States.
• All of the above will cause cap rates and property values to decrease.

Remember that increased debt service based upon higher interest rates is not considered in the capitalization approach. But, as interest rates rise, borrowers will feel the sting of higher debt service payments. Some property transactions may become less appealing financially. As purchasers and borrowers elect not to purchase, that may compound and create more unsold inventory. Some sellers may get desperate and reduce the price to sell quickly. The lowered price would result in a higher cap rate. Higher interest rates will lower all real estate prices on a macro level.

How dramatic will lower real estate prices be over time? Between 2007 and 2010, we witnessed the downward value contagion spread, resulting in substantially lower values and increased Capitalization Rates.

The four-pronged whammy is not a new phenomenon. It has just been forgotten while enjoying the Federal Reserve's free-for-all, 200-proof-infused financial punchbowl.