The Irony Of Cap Rates

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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 Formula

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:

Method Revenue Expenses NOI Period Calculated
1 T-12 T-12 T-12
2 T-6 T-12 Annualized T-6
3 T-3 T-12 Annualized T-3
4 T-1 T-12 Annualized T-1
5 T-1 Budget – Year 1 T-1 with Budget Expenses
6 Budget – Year 1 T-12 Budget 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.

  • Investment 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 un-scrubbed NOI.
  • 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.”
  • Appraiser – 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 income.

Once 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.

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