Cap Rate Trends, Methodology and Analysis Dane R. Anderson MAI, CCIM Appraisal & Litigation Services Director 1
Quickly The Income Approach Basis of the Approach Present worth of future benefits Two Methods: Direct Capitalization One year s income converted to value Yield Capitalization (Discounted Cash Flow) Multiple years income and likely reversion (future sale) converted to a present value using a yield rate Chapter 21, The Appraisal of Real Estate, 14 th Edition 2
Quickly Direct Cap, Cap Rate and Theory Value = Net Operating Income (NOI) Overall Capitalization Rate Value = Income x Factor Overall Capitalization Rate = Capitalization Rate = Cap Rate = OAR = Ro = R 3
Quickly Direct Cap, Cap Rate and Theory Example Office Building with $500,000 of NOI 10% Cap Rate $500,000 / 10% = $5,000,000 4
Quickly The Cap Rate and Theory What s a Cap Rate? Overall Capitalization Rate (Ro) An income rate for a total real property interest that reflects the relationship between a single year s net operating income expectancy and the total property price or value. (Page 456 of 14 th edition of The Appraisal of Real Estate) Layman s Definition of Cap Rate The ratio between a single year s net operating income and its value. 5
RERC Real Estate Report Overview 2 nd Quarter 2013 Report Currently Out 3 rd Quarter Report Due Out in November Currently in its 40 th Year of Production Investor ratings, investment criteria, economic data, and commentary 6
RERC Real Estate Report Laying the Foundation Some Definitions Institutional: High quality (minimum value of $5 million per property) commercial real estate that is generally owned or financed at least in part by taxexempt investors on behalf of beneficiaries in a fiduciary environment (i.e., public and corporate pension funds, endowments and foundations, life insurance companies, commercial banks, real estate investment trusts, sovereign wealth funds, etc.). 7
RERC Real Estate Report Laying the Foundation Some Definitions Regional: Generally average to good quality (below $5 million per property) CRE, that is income producing but more local in nature. RERC s regional survey respondents generally work on a metro, statewide, or regional level. 8
RERC Real Estate Report Laying the Foundation Some Definitions 1 st Tier Investment Properties new or newer quality construction in prime to good locations. 2 nd Tier Investment Properties aging, former firsttier properties, in good to average locations. 3 rd Tier Investment Properties older properties with functional inadequacies and/or marginal locations. 9
Recent Trend in Yield and Cap Rates Source: RERC, 2Q 2013. 10
Yields Up, Cap Rates Fluctuating Preliminary 3 rd Quarter Data 11
Regional Required Cap Rates 12
48 Metros Covered Here is Chicago 13
Time to Buy, Sell, or Hold? Historical Buy Sell Hold Recommendations (Preliminary 3 rd Quarter Data) Rating Source: RERC, 3Q 2013. 14
Investment Conditions Preliminary 3 rd Quarter Data 15
CRE vs. Alternatives 16
Strength of CRE Moving Forward NCREIF Value Index Sources: NCREIF, NBER, 2Q 2013. 17
RERC NPI Forecast Sources: NCREIF, RERC, 2Q 2013. Note: Shaded area reflects RERC s outlook for the Base, Upside, and Downside scenarios, from 3Q13 to 1Q15. RERC projects a value change in 2013 between 3% and 8.25%. With income return of 6%, total unleveraged returns are expected to range from 9% to 14.25%, with the base case near 12.5% for the year. 18
Cap Rate Methods and Analysis Methods of Deriving a Cap Rate Strengths/Weaknesses Pitfalls Practical Examples of Common Issues 19
Derivation of the Cap Rate Analytical Methods: Extraction from Sales Band of Investment Underwriter s Method (Debt Coverage Analysis) Qualitative Methods: Investor Surveys Market Participant Interviews 20
Sales Extraction Method Formula Again: Ro = Io/Vo Strengths Market derived Easy to understand and explain Preferred method according to the 14 th edition of The Appraisal of Real Estate (page 493) Often utilized by market participants Implicitly reflects buyer/seller investment assumptions about each individual sale Weaknesses Rife with pitfalls No standard method of NOI derivation Gross leased properties include more potential issues than net leased Data from an inefficient market Easily manipulated, especially when estimated from fee simple sales A historical, not current, indication Sales Extraction covered on pages 493 495 of The Appraisal of Real Estate, 14 th edition 21
Sales Extraction Method Potential Pitfalls Source and basis of NOI Above/below market rents Stabilization of property Physical differences Vacancy and collection loss Economic differences Cash equivalency issues Buyer/seller motivations Turnover/tenant risk Dated sales Near term capital expenditures Leased fee sales for fee simple valuations Differing levels of appreciation Sale leaseback/operating leases Conditions of sale Inadequate data 22
Sales Extraction Pitfalls Different Bases of NOI Example Comparable Building Sold for $1,000,000 Basis Indicated NOI Cap Rate Actual Year End 2012 $75,000 7.5% Annualized 9 Month YTD $100,000 10.0% Broker Pro Forma $130,000 13.0% Subject Appraiser s Stabilized Estimate $150,000 15.0% Which cap rate is correct? Without knowing more, what appears to have been happening? Does this happen in practice? 23
Sales Extraction Pitfalls Different Bases of NOI Example Subject Value Impact Subject stabilized NOI: $110,000 Fee simple analysis Source of Comparable NOI Cap Rate Indicated Subject Value Actual Year End 2012 7.5% $1,466,667 Annualized 9 Month YTD 10.0% $1,100,000 Broker Pro Forma 13.0% $846,154 Subject Appraiser s Stabilized Estimate 15.0% $733,333 24
Sales Extraction Pitfalls Different Sources of Extracted Cap Rate Appraiser s Within an Office Analyzing Subject s Differently $200/unit vs. $350/unit reserve for apartments One appraiser stabilizes the NOI and another uses actual Data From Different Appraisal Offices XYZ Appraisal Company appraised the property and said the cap rate was X.X% Broker John Doe, the selling broker, indicated the cap rate was X.X% Same issues as from the other appraisal office 25
Sales Extraction Pitfalls Different Bases of NOI Example Apartment Reserves $200/unit vs. $350/unit 100 Unit apartment building, $4,000/Unit NOI before reserves, 8% Cap Rate $4,750,000 vs. $4,562,500 4% Difference Other Areas This Happens: Management Fee Vacancy and Collection Loss Repairs & Maintenance Income Lease Up Discounts or Premiums Variable Expenses Non stabilized Properties 26
Sales Extraction Pitfalls Turnover / Tenant Risk Long term leased properties sell for lower capitalization rates When does lease term start to impact the capitalization rate? < 3 Years < 5 Years < 10 Years < 20 Years Discount to Base Rate Base Premium in Price/Lower Cap Rate Moderate Premium over 10 Yrs 27
Sales Extraction Pitfalls Different Sources and Bases But these are small issues do they really impact value? Yes, cumulatively they result in significant differences in value Can show inconsistency in methodology Can help bring the two sides closer together 28
Band of Investments Primary Method is Mortgage/Equity Analysis: Mortgage Component + Equity Component = Capitalization Rate Calculation of Mortgage and Equity Components: Mortgage Component = M x R M Equity Component = E x R E M = Loan to value ratio E = Equity ratio R M = Mortgage capitalization rate (mortgage constant) R E = Equity capitalization rate (equity dividend rate) 29
Band of Investments Strengths Relatively easy to understand/explain Data available in the market Weaknesses Not typically utilized by market participants Inputs from an inefficient market Potential Pitfalls Low interest rate environment limits applicability Age/condition of property Near term capital expenditures Inputs not always market derived Easily manipulated Band of Investments covered on pages 495 497 of The Appraisal of Real Estate, 14 th edition 30
Band of Investments Example Lender Indicated Terms 5 6% interest rate 20 to 25 year amortization period 3 to 7 year term and 70 75% LTV Equity Dividend Rate Investor Survey 7 12%, average 9% Extracted from Sales 4 7% 31
Band of Investments Example What do the lender and EDR data indicate? Assume 5.5% interest rate (average) Assume 75% LTV Assume 9% EDR What s the cap rate with 20 vs 25 year amortization? 25 year indicates 7.78%, 20 year indicates 8.44% On a property with $1,000,000 in NOI: 25 year amortization: $12,820,510 20 year amortization: $11,848,340 +/ 7.5% change 32
Debt Coverage Ratio Method The Debt Coverage Ratio (DCR) Formula: DCR = I O /I M The DCR formula manipulated to indicate the following formula: R O = DCR x R M x M DCR Method covered on pages 498 499 of The Appraisal of Real Estate, 14 th edition 33
Debt Coverage Ratio Method Strengths Derived with only lender info Weaknesses Not typically utilized by market participants Less intuitive than other methods Doesn t consider investor requirements Potential Pitfalls Low interest rate environment makes it less reliable Non stabilized properties and resulting NOI utilized Age/condition of property Near term capital expenditures Inputs not always market derived Easily manipulated 34
DCR Method Example Same Mortgage Terms as for Band of Investments: Assume 5.5% interest rate (average) Assume 75% LTV Assume 9% EDR Assume 1.25 DCR requirement What s the Cap Rate With 20 vs 25 yr Amortization? 20 year amortization 7.71% = 1.25 x 8.22% x75% 25 year amortization 6.68% = 1.25 x 7.34% x 75% 35
Published Investor Surveys Strengths Utilized by investors/buyers/sellers Directly reflects recent market participant investment criteria Very easy to understand/explain Historical surveys useful for retrospective valuations Avoid pitfalls of individual transaction rates of an inefficient market Weaknesses No standard method of NOI derivation Basis of derivation can differ from subject appraisal premise Limited data for secondary markets Limited data for tertiary markets Not typically relevant for noninstitutional grade properties Surveys covered on page 499 of The Appraisal of Real Estate, 14 th edition 36
Published Investor Surveys Potential Pitfalls Application of data to property types not covered Utilization for non institutional grade properties Utilization in secondary or tertiary markets Averages often cited but not necessarily appropriate 37
Market Participant Interviews Strengths Directly reflects current market participant investment criteria Very easy to understand/explain Weaknesses No standard method of NOI estimation One market participants opinion not reflective of a market Hard to have market participants estimate retrospective opinions Potential Pitfalls Guiding the market participant Appraiser interpretation of interview Brokers and investors have their own agendas 38
Concluding Points Primary pitfall not obtaining and verifying reliable data. Each cap rate estimation method includes potential for manipulation. Real estate markets are not always efficient. 39
A successful man is one who can lay a firm foundation with the bricks others have thrown at him Thank You!! Questions? 40
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