Objective Value Is A Matter Of PerspectiveBy Adam Karnes
A capitalization rate, or cap rate, is
a useful tool in a real estate investor’s valuation arsenal. Everyone seems to
use them, but how do we define them? While researching for this article, I was
struck by how many definitions there seems to be for a single concept. I asked
four real estate professionals: “What is a cap rate?” And I received four
different answers. The first quoted a textbook or Investopedia, answering that a
cap rate is equal to net operating income (NOI) divided by fair market value. Another
by-the-book individual responded that a cap rate is defined as the expected
rate of return on an unlevered real estate asset based on the income the
property generates. A third, more verbose individual responded with a
long-winded explanation about the relationship between NOI, location, quality,
sales comparables, and everything in between. The last simply responded, “that
depends”. Who was correct? In actuality, all of the above were correct.
The first two answers are straight forward, objective definitions. The remaining responses are more speculative (subjective) in nature. For fear of sounding like a philosophy professor, suffice to say that the deeper I dug for an answer, the more dirt I had to clear. In fact, answers to questions like “What is a cap rate?” and “What cap rate is appropriate for this asset?” are remarkably dependent on perspective. Maybe “that depends” was the most accurate answer after all. Let’s briefly examine the math behind the first answer.
The cap rate formula (Cap Rate = NOI/Value) looks like a simple division problem. However, before calculating a cap rate based on that formula, one must derive a facility’s true operating income. Operating income equals revenue less operating expenses. Revenue is comprised of rent, fees, and goods sold. Operating expenses can be categorized into common line items such as taxes, insurance, management fees and payroll, utilities, repairs and maintenance, advertising, and general and administrative. Personal expenses, one-time expenses, debt service and interest payments, depreciation and amortization, and any other non-operating expenses should be omitted. Once the operating expenses have been verified, subtract that number from the income to determine a facility’s NOI. Simple, right? Well, maybe not.
The question of “Whose NOI is being used?” comes into play; “For which period is NOI being calculated?” is also a valid question. Depending on where the asset is in its lease-up, there are multiple periods of time for which one might calculate NOI. The following table compares different periods of NOI which can be calculated using various combinations of revenue and expense:
– Year 1
with Budget Expenses
– Year 1
with Trailing Expenses
Depending on who is in the driver’s
seat, the view on cap rates can be drastically different. Is the driver looking
out the window or in the rear-view mirror? When looking in the mirror, the
driver sees what is behind him; caution: objects in mirror are closer than they
appear! When looking out the window, he sees what is in front of him. But even
looking out the window begs the question “which window?” So, how does each
party quantify and utilize cap rates?
Cap Rate, Party Of Four
Below are four views on the cap rate discussion from an investment sales broker, buyer (owner), lender, and appraiser. All of whom have a vested interest in getting the value of the property right.
Sales Broker – If a self-storage owner hires an investment sales broker, they have
one goal in mind: Sell my property for as much money as you can. Go ahead and sugar
coat it, but, apart from smooth execution, there isn’t much more you can ask of
them. Therefore, a seller’s broker will lead the market by seeking out high per
square foot comps trading at low (but supportable) cap rates; if these comps
are relevant, it builds the case for an elevated sales price.
Buyer – Buyers are
in an intriguing position. On one hand, they want to be able to challenge the
purchase price if underwriting dictates that they will pay too much for an
asset. However, if a buyer is funding part of the purchase with debt, they want
to be sure to omit any non-operating expenses. Underwriting above-market
expenses can mean leaving loan dollars on the table. Revisiting the table
above, the buyer may calculate a value based on methods one to four for a look-back
perspective. The buyer utilizes methods five and six to project the asset’s
income producing potential going forward. A prudent buyer strives to unearth an
asset’s true NOI, before carefully weighing this against asking price as well
as his expected return on investment. While a cap rate will help value an
opportunity, the pieces should be in place before “slapping a cap rate” on an
Lender – Lenders
are concerned with the proven operations of a storage facility. For that
reason, they will underwrite some combination of trailing revenue and
annualized trailing expenses (method one or two). This is because lenders aren’t
in the business of false optimism or wagering on proforma income. One CMBS
lender shared thoughts on the usefulness of cap rates. Here is the abridged
response: “First, we come up with what we believe is a realistic assumption of
value. We obviously rely on a third party (appraiser) to guide us towards that
value. We ask the appraiser about the cap rate assumption they are making, but
we are generally focusing more on debt yield (NOI/loan amount), because the
math is less subjective. That said, the mentality on debt yields is congruent
with how we view cap rates; cap rates are dependent upon the asset and market
in question, as well as the cash flow. A B-piece buyer in our deals will
commonly scrap the cap rate as irrelevant or ambiguous for a refinance loan.”
– Appraisers use three approaches to determine value, a direct cap
approach (income), sales comparable approach, and the cost approach to
reconcile a final value. Of all parties in a transaction, appraisers are the
only ones who have any business “assigning” cap rates in their direct cap
approach. This is because the nature of an appraiser’s job is to assist in
valuing a real estate asset through examination and research. There is a reason
that an appraisal conducts an extensive analysis of all relevant information
before addressing the transactions implied cap rate. Appraisers will analyze the
local and regional market, demographic and population statistics, supply and demand
characteristics, industry trends, comparable sales, as well as property-level
again, I turned to an appraiser from a major self-storage valuation group for support.
According to this individual, a range of acceptable cap rates is determined.
Ultimately, the capitalization rate applied is shaped by the following (and
other) considerations: “Is the facility stabilized, newly opened, or under
construction? It depends on location, whether that be a dense urban area or a
rural area; the quality of the asset, build characteristics, climate-controlled
or not, required deferred maintenance, and amenities all impact the cap rate …
Generally speaking, lower cap the closer the property is to a city center. In
addition, investors are willing to pay a slight premium for properties that are
stabilized, which puts downward pressure on the cap. Terminal cap rates are
typically 25 to 50 basis points above the going-in cap rate. We also use income
multiples to audit the cap rate.”
This response reinforces that all
roads lead back to subjectivity and the importance of transaction-specific
factors. Large appraisal groups have done thousands of self-storage appraisals,
so why not just select a few comps out of a hat, slap a cap rate on the asset,
and call it a day? Because every transaction is different, with its own set of
variables. Identifying relevant sales comps and understanding the “story” are
crucial prerequisites to accurately valuing an asset.
At the end of the day, the revenue and
expenses, as well as the state of the market, drive value. A cap rate is just a
way of conveying the current market proxy for value. To be sure, cap rates aid
in the valuation of commercial assets, but every tool has limitations.
There are correct and incorrect ways
to use a cap rate, and understanding the perspective makes all the difference.
If used incorrectly, an investor risks missing out on a good deal because they
are hung up on a cap rate. However, if used correctly, cap rates are a very
nifty tool in the valuation tool belt.
Adam Karnes is a senior credit analyst at Chicago-base The BSC Group, where he specializes in the packaging of debt and equity financing requests for all commercial property types nationwide, with an emphasis on self-storage assets.