Capitalization rates, better known as “cap rates”, are truly in the eye of the beholder. Different market participants could come up with different cap rates for the same property even when analyzing the same financial statements. One person’s 5 cap could be another’s 5.5 cap. Better yet, it could be a broker’s 8 cap! How do we sort through all of these cap rates? Let’s use the following example deal to learn more about the various cap rates.
You see an email blast that Blue Collar Apartments just went up for sale. You become very excited because you ride your bike through the apartment community every summer and think about how great it would be to own this asset. You don’t have a life, but that is ok because you just executed the Confidentiality Agreement and have been granted access to the virtual deal room. The deal package is downloaded and includes the following financial statement.
Blue Collar Apartments
| Income | 2018 YE |
|---|---|
| Gross Potential Income | $600,000 |
| – Economic Vacancy | ($50,000) |
| = Net Rental Income | $550,000 |
| + Other Income | $20,000 |
| = Effective Gross Income | $570,000 |
| Expenses | |
|---|---|
| General & Administrative | $30,000 |
| Marketing & Advertising | $5,000 |
| Payroll (On-Site Management) | $45,000 |
| Utilities | $18,000 |
| Repairs & Maintenance | $40,000 |
| Property Taxes | $75,000 |
| Insurance (Property/Liability) | $10,000 |
| Management Fee (5%) | $28,500 |
| Total Expenses | $251,500 |
| Net Operating Income | $318,500 |
|---|---|
| – Debt Service | ($75,000) |
| – Asset Management Fee | ($15,000) |
| = Net Cash Flow | $228,500 |
Commercial property values are derived using the property’s net operating income (NOI). A property’s NOI is calculated by subtracting all property level expenses from total revenues generated. NOI is a measure of how much money the property’s operations are generating. Debt service and asset management fees are considered “below the line” items and come after NOI. While one owner could get 10 years of interest only financing at 4%, another might obtain financing at 5% on a 20 year amortization schedule. A buyer may purchase the asset for his/her family and may not have investors who will pay an asset management fee. A $1 billion fund could be the buyer and charge their investors a fee based on equity undermanagement.Since the property’s financing has nothing to do with property level operations, the debt service payments are excluded. Using NOI to compare properties provides us with an apples-to-apples approach.
We ignore the below the line items and understand that the property’s NOI was $318,500 in 2018.
| Net Operating Income | $318,500 |
|---|---|
| – Debt Service | ($75,000) |
| – Asset Management Fee | ($15,000) |
| = Net Cash Flow | $228,500 |
The offering memorandum shows the property as unpriced so we call the broker for some pricing guidance. The broker advises us that this deal will trade at above a 7% capitalization rate or “cap rate”. A cap rate, in its most basic form, is a property’s net operating income divided by the purchase price.
Apartments routinely trade for much lower cap rates so we excitedly do the following math:
| Net Operating Income | $318,500 |
| Capitalization Rate | 7.0% |
| Purchase Price | $4,550,000 |
“So this will shake out around $4.5 million?” we ask the broker. The broker laughs and advisesthat the deal will trade around $6 million.
$6 million? That is no 7 cap ! Sure looks like a 5.3% cap to me.
| Net Operating Income | $318,500 |
| Capitalization Rate | 5.3% |
| Purchase Price | $6,000,000 |
“The property is horribly mismanaged. Some light operational improvements in year one Are needed, that’s all. Check out our projections in the offering memorandum”.
We open the offering memorandum again to review the broker’s assumptions versus the historical financials.
Blue Collar Apartments
| Income | 2018 YE | Broker Projections |
|---|---|---|
| Gross Potential Income | $600,000 | $675,000 |
| – Economic Vacancy | ($50,000) | ($40,000) |
| = Net Rental Income | $550,000 | $635,000 |
| + Other Income | $20,000 | $25,000 |
| = Effective Gross Income | $570,000 | $660,000 |
| Expenses | ||
|---|---|---|
| General & Administrative | $30,000 | $20,000 |
| Marketing & Advertising | $5,000 | $12,000 |
| Payroll (On-Site Management) | $45,000 | $35,000 |
| Utilities | $18,000 | $13,000 |
| Repairs & Maintenance | $40,000 | $30,000 |
| Property Taxes | $75,000 | $80,000 |
| Insurance (Property/Liability) | $10,000 | $5,000 |
| Management Fee | $28,500 | $19,800 |
| Total Expenses | $251,500 | $214,800 |
| Net Operating Income | $318,500 | $445,200 |
| NOI Margin | 55.9% | 67.5% |
| Cap Rate | 5.3% | 7.4% |
I know the expenses can be reduced but the broker’s projections seem kind of aggressive. They cut payroll and barely adjusted for a property tax reassessment. They moved the management fee from 5% to 3% when we know property management firms typically charge 5% for this size deal. I am not sure we can rely on these projections or the cap rate the broker whispered.
At the very least, we should adjust for a property tax reassessment. After doing the property tax analysis we determine that the property taxes will increase to $100,000 after the sale. From this, we can derive an acquisition cap rate that is adjusted for property tax reassessment.
| In-Place NOI | $318,500 |
| Projected Property Tax Increase | ($25,000) |
| NOI (Adjusted for Taxes) | $293,500 |
| Purchase Price | $6,000,000 |
| Cap Rate Adjusted For Taxes | 4.89% |
Yikes, a 4.9% cap sucks. We can’t be that pessimistic though since the property is terribly mismanaged and we know there is a lot of value to unlock. Let’s finish our proforma and normalize some of the expenses that are too high so we can arrive at a *proforma cap rate*.
It is important to normalize expenses when determining the proforma cap rate. Does the owner’s financials have a management fee? Other market participants are going to factor in a management fee so you should too. Does the owner self-manage the property and not show any payroll expense? The financials need to be adjusted to account for payroll because someone needs to manage the property and, once again, other market participants are going to reduce the projected NOI to account for a manager’s salary. Even if you are going to manage the property, your time is worth something and needs to be accounted for. Make sure the financials have an insurance figure included and show the correct property tax liability. If not, we will have to account for these too.
We come up with the proforma shown below after normalizing expenses and estimating the first year’s income.
Blue Collar Apartments
| Income | Blue Collar Proforma |
|---|---|
| Gross Potential Income | $650,000 |
| – Economic Vacancy | ($60,000) |
| = Net Rental Income | $590,000 |
| + Other Income | $22,000 |
| = Effective Gross Income | $612,000 |
| Expenses | |
|---|---|
| General & Administrative | $22,000 |
| Marketing & Advertising | $20,000 |
| Payroll (On-Site Management) | $55,000 |
| Utilities | $15,000 |
| Repairs & Maintenance | $35,000 |
| Property Taxes | $100,000 |
| Insurance (Property/Liability) | $9,000 |
| Management Fee | $30,600 |
| Total Expenses | $286,600 |
| Net Operating Income | $325,400 |
| NOI Margin | 53.2% |
| Cap Rate | 5.4% |
A 5.4% proforma cap feels pretty good relative to the other deals we have underwritten lately which have been going down into the sub-5 cap range.
This deal has a lot of upside as we can renovate the units and push rents to market rates. We are projecting that the renovation program will be completed within the first three years. The Year 4 proforma NOI is $540,000.
We can derive our *stabilized cap rate* by dividing our stabilized NOI into the purchase price.
| Blue Collar Proforma | Year 4 |
|---|---|
| Effective Gross Income | $855,000 |
| Total Expenses | ($315,000) |
| Net Operating Income | $540,000 |
| Purchase Price | $6,000,000 |
| Cap Rate (Stabilized) | 9.0% |
Finally, we need to place an *exit cap rate* on our sale year NOI to project how much we think we will be able to sell the property for at the end of the investment period. To be prudent, we place a 25 to 75 basis point buffer on our initial cap rate since we don’t know what the investment environment will be when it comes time to sell.
Let’s take our 5.5% cap rate and add 0.50% to assume a 6% exit cap.
| Blue Collar Proforma | SALE Year |
|---|---|
| Net Operating Income | $650,000 |
| Exit Cap | 6% |
| Sale Price | $10,833,000 |
Using a 6% exit cap rate, we project that we can sell the property for approximately $10.8 million. The exit cap rate is also required to determine the project’s feasibility using the Internal Rate of Return function in Excel. While we don’t need to forecast a final sale price to determine the annual cash-on-cash yields, it is required to determine the project’s IRR since the IRR is a cumulative measure that considers all cash flows.
Let’s recap all the different cap rates that we discussed.
- Acquisition Cap Rate – the actual in-place NOI is divided by the purchase price
- Cap Rate Adjusted for Taxes – in-place NOI is adjusted for property tax reassessmentand divided by the purchase price
- Proforma Cap Rate – the in-place NOI is adjusted by the buyer to account for normalized expenses and a Year 1 revenue projection then divided by the purchase price
- Broker Cap Rate – an often very rosy NOI projection provided by the broker which is divided by the purchase price
- Stabilized Cap Rate – the stabilized proforma NOI divided by the purchase price
- Exit Cap Rate – the cap rate used in the proforma to project the sales price at the end of the investment period. Acquisition/development professionals typically add 0.25% to 0.75% to the market cap rates to provide a buffer in their analysis
Different professionals will have different names for the same cap rates; like tomato being pronounced “tomayto” or “tomahto”. If you don’t understand the cap rate in someone’s analysis, just ask for more detail about the assumptions they used to get to their cap rates. Always take the time to make sure the assumptions include all the expenses that will be required to run the property or you could be stuck with an artificially inflated cap rate.