Peeling The Onion on Capitalization Rates

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1 The compression in cap rates during the commercial real estate (CRE) bubble led to miscalculations on the part of many sophisticated investors in regards to exit valuations. As we quantitatively demonstrate below, an increase in capitalization rates or overly optimistic forecasts regarding growth in cash flow will have significant detrimental effects on exit valuations and projected internal rates of returns (IRR). We first review the ABCs of Capitalization Rates in Section I and follow with a discussion of misguided assumptions made in valuing assets during the CRE bubble in Section II (p.2). would soon legitimize their I. The ABCs of Capitalization Rates purchase prices. As capitalization rates are useful for benchmarking the value of an asset, they are ubiquitous in the CRE industry. Direct capitalization is simply applying an appropriate percentage to next year s stabilized cash flow. The cap rate is the property s projected year 1 cash flow as a ratio to the sales price. For example, if the unlevered cash flow is $100,000 and the purchase price is $1,000,000, then the cap rate is 10%. Purchase Price ($1,000,000) = Cash Flow ($10,000) / Cap Rate (10%) When Cash Flow = Revenue Expenses Normalized Capital Expenditures Shifting the equation s components, if you paid $1,000,000 for a building, without the benefit of a mortgage, and at a 10% cap rate, you would have a 10% expected yield from your investment. Dividend Yield (10%) = Cash Flow ($10,000) / Purchase Price ($1,000,000) Unfortunately cap rates almost always are expressed as a percentage of net operating income in the CRE industry. The leading brokerage firms typically market assets for sales using net operating income and not cash flow. However, income producing real estate has operating expenses, capital reserves, broker commissions, tenant improvements and capital expenditures to be paid or accrued prior to dividends being realized. We typically rely on the following formula when utilizing cap rates to estimate the value of a property: Purchase Price = (Net Operating Income Normalized Capital Expenditures) / Cap Rate When Net Operating Income = Revenue Expenses Capital Reserves The bubble years of reflected the herd mentality of Wall Street investors who booked fees, paid bonuses, and professed a belief that rental growth Cap Rates vs. Return on Equity: Cap rates are the cash flow yield you would receive if you acquired the building without a mortgage. Accordingly, cap rates do not represent a return on equity or dividend yield when a mortgage is in place, as the cash flows of a levered asset are allocated first to the mortgagee and then to the investor. If the property has a mortgage, its net cash flow available for dividends would be the cash flow less the amount of the interest and amortization payments. Net cash flow is defined as: Net Cash Flow = NOI Normalized Capital Expenditures Interest Amortization 1 Odessa Realty Investments, LLC

2 The use of leverage will increase your returns, as it should, since your equity investment is now riskier due to the mortgagee s senior claim on the asset. High leverage implies increased financial risk, which in turn requires a higher yield to equity. Net cash flow is utilized to calculate your yield on the initial investment. Investors call this cash-on-cash returns. (Please see our discussion elsewhere on determining the risk adjusted yield required for cash-on-cash returns.) We also add back the mortgage amortization payments (which increase your equity position in the property) to the free cash flow and divide this sum by the initial investment to calculate the Return on Equity percentage. Only by satisfying what the mortgage and equity require as returns for a given building can you determine a purchase price and resulting cap rate. Thus, cap rates are actually the end result of your calculations, a non-essential financial metric that reflects the blended cost of debt and equity capital. Real estate investors begin with capitalization rates in valuing a property because it is an easy and commonly used metric. Importantly, assuming you leverage your investment with a mortgage, the financial results you really care about are cash-on-cash returns or Return on Equity. Forward NOI vs. Trailing NOI: The NOI used for cap rate formulas is typically based on the cash flow projected for year 1. This is problematic because it requires accurately forecasting the future, and if you overestimate the cash flow for year 1, you will effectively be paying the seller for dividend yield that never materialized. Then you would have violated one of our golden rules: Never pay the seller for your upside! Paying too high of a price and The rationale for forward pricing in the real estate market or equity markets is that your investment will be compensated with the receipt of future net cash flow, not trailing net cash flow. For example, if you buy a publically traded stock that pays a dividend, you are collecting dividends paid by the company after not before - you bought the stock. Finance theory appropriately defines returnon-investments based on future cash flows. relying on unrealistic growth assumptions to rationalize a purchase will inevitably lead to a loss of investment. Our recommendation is to be very conservative in your estimate of future NOI when valuing a property. We carefully review the previous calendar year s NOI, latest-twelve-months NOI and latestthree-months NOI annualized to make sure the projected NOI has some semblance to reality. We never include rents that are not in place, although in certain circumstance we might be more aggressive in our valuation if we anticipated leasing the vacant space in a reasonable time period. II. The Bubble Investors and their Follies A small increase in cap rates can have a tremendous negative impact on the valuation of your asset. During the bubble years of , Wall Street investors were acquiring run-of-the mill A assets for capitalization rates of 5% and sometimes lower. They made these purchases by over estimating cash flow growth while ignoring the potential impact of higher cap rates in the future. As Table 1 below demonstrates, assume an asset has net operating income (NOI) of $100,000 a year, and sells for $2,000,000, with a capitalization rate of 5%. If the capitalization rate in subsequent years is 7%, with no change in NOI, then the market price would be $1,420,000, a decline of 29%. Your net operating income would need to grow at 7% every year for five years to offset this two hundred basis point increase in the cap rate 1. 1 The impact on valuation resulting from a percentage change in cap rates is less as the cap rates get larger. 2 Odessa Realty Investments, LLC

3 Table 1: Required NOI Growth to Offset Increase in Cap Rates from 5% to 7% NOI Growth Rate 7% 7% 7% 7% 7% NOI $100,000 $106,961 $114,407 $122,371 $130,889 $140,000 Cap Rate 5% 7% 7% 7% 7% 7% Asset Value $2,000,000 $1,528,015 $1,634,381 $1,748,150 $1,869,840 $2,000,000 Asset Value Gain (Loss) -471, , , ,160 0 The bubble years of reflected the herd mentality of Wall Street investors who booked fees, paid bonuses, and professed a belief that rental growth would soon legitimize their purchase prices. We recall trying to acquire A properties and always being outbid by ridiculous amounts, to the point that in September 2005 we recommended to our board of directors (of a different legal entity) that all real estate assets be sold no later than December Many Wall Street investors rationalized their low purchase prices by over estimating the forward NOIs. For instance, New York City's Peter Cooper Village apartment complex was acquired in a landmark deal at a cap rate of 5% based on highly aggressive hockey stick projections you should be sitting for this - on year 5 NOI. The valuation for this transaction was dependent on highly problematic projections and assumptions and still would only achieve a 5% cap in five years. (To think that quite a few very smart people had fingerprints on this deal.) Needless to say, the transaction concluded in bankruptcy (as we predicted in 2006) after the bubble burst. Justifying paying a low cap rate requires conviction in the potential for significant increases in rental rates and NOI. For example, assume an asset with $500,000 of NOI projected for year 1 is acquired at a cap rate of 6.25% with a mortgage rate of 5.25% (with a 63% loan to value and a 1.25x mortgage payment coverage). Let s look at the cash-on-cash returns and the IRRs with rental growth rates of 2.5% (Table 2) and 5% (Table 3), all other factors held constant. As Table 2 demonstrates, assuming a 2.5% NOI perpetual growth rate, the property achieves an IRR in year 5 of 10.25%. Table 2: Investment Returns with Low Cap Rate and 2.5% NOI Growth NOI GROWTH 2.50% 2.5% 2.5% 2.5% 2.5% NOI $500,000 $512,500 $525,313 $538,445 $551,906 $565,704 Cap Rate 6.250% 6.250% 6.250% 6.250% 6.250% 6.250% Asset Value $8,200,000 $8,405,000 $8,615,125 $8,830,503 $9,051,266 $9,277,547 Net Cash Flow $93,514 $105,139 $117,055 $129,268 $141,787 $154,619 Cash-on-Cash Return 3.08% 3.47% 3.86% 4.26% 4.67% 5.10% IRRs % 7.38% 9.09% 9.86% 10.25% The same property with a 5% perpetual rental growth realizes an IRR of 15.45%, as shown below in Table 3. 3 Odessa Realty Investments, LLC

4 Table 3: Investment Returns with Low Cap Rate and 5% NOI Growth NOI GROWTH 5.00% 5.00% 5.00% 5.00% 5.00% NOI $500,000 $525,000 $551,250 $578,813 $607,753 $638,141 Cap Rate 6.250% 6.250% 6.250% 6.250% 6.250% 6.250% Asset Value $8,400,000 $8,820,000 $9,261,000 $9,724,050 $10,210,253 $10,720,765 Net Cash Flow $84,454 $107,704 $132,116 $157,749 $184,664 $212,925 Cash-on-Cash Return 2.72% 3.47% 4.25% 5.08% 5.94% 6.85% IRRs 0.00% 8.01% 13.32% 14.78% 15.29% 15.45% Our point is simply that the world has to remain near perfect to achieve 5% year-after-year rental growth with no change in operating margins and capitalization rates over 5 years. In 2005 we witnessed buyers in a few over-priced markets model 5% rental growth only to achieve about 0% rental growth over the ensuing years. Supply and demand dynamics typically will not allow real rental pricing increase of any magnitude for a sustainable period as new product will be introduced into the market place. Even capacity constrained markets such as New York City witnessed tremendous increases in housing and office capacity over the past ten years. Furthermore, if cap rates are at historic lows, they are likely to revert to the mean, and higher cap rates result in lower exit valuations. Buyer beware; a low cap rate purchase targeting IRRs in the 10% to 15% range requires considerable rental growth rates, flat capitalization rates, stable supply and demand dynamics, and five long years. New York City office rents for midtown Manhattan demonstrate the risk in projecting rental growth rates, as demonstrated in Table 4 below. Table 4: Office Rents and Growth Rates in Mid-Town Manhattan Year Total Rent $60.26 $66.27 $75.42 $90.05 $ $96.86 $65.49 Annual Growth 5.0% 13.8% 19.4% 16.1% -7.4% -32.4% 5-Year Growth Rate -2% 0% 8% 13% 9% -3% Landlord Effective Rents $31.76 $28.78 $37.33 $51.26 $64.06 $52.44 $19.57 Annual Growth 8.9% 29.7% 37.3% 25.0% -18.1% -62.7% 5-Year Growth Rate -7% -3% 13% 28% 16% -10% Source: Studley The mid-town office market was one of the hottest real estate plays in the country during the bubble. Total Rents in mid-town NYC went from $63 per square foot in 2003 (not shown) to $105 in 2007, a 5-year annual growth rate of over 13%! However, after the bubble burst in 2008, the rents per square foot went down to $65 during The 5-year annual growth rate as of the end of 2009 was a negative (-3%) and effective rents in 2009 average only $5 more than the $60 per square foot rents of 1999 (1% compound annual growth). 4 Odessa Realty Investments, LLC

5 More problematic for New York City office owners is that Landlord Effective Rents in mid-town NYC cratered from a peak of $64 in 2007 down to $19 in The five year average growth for Landlord Effective Rents went from a 28% trailing average in 2007 to a negative (-10%) in The investors who bought mid-town office buildings during the peak lost fortunes banking on increased rental growth. Spread between Cap Rates and Mortgage Rates: Is there a rule-of-thumb for how much spread is needed between cap rates and mortgage rates to appropriately value an asset? Not really, as the spread between cap rates and mortgage rates varies depending on the amount of leverage, quality of asset, cash flow margins and the capitalization rate, among other factors. While top quality A assets typically require approximately a 2.25% to 3.25% spread between the interest rate and the capitalization rate to be economically attractive, this indicative amount changes meaningfully depending on circumstances and is difficult to rely on. The appropriate spread between a cap rate and a mortgage rate will vary by asset. III. Conclusion The strength of cap rates is its simplicity and familiarity in the commercial real estate industry. Similarly, investors often cite gross rent multiples which are simply the sales price divided by next year s stabilized gross rents. Also common are price per square foot and price per unit calculations. All these metrics are handy if you know a particular submarket very well, but can be highly misleading when related to cash-on-cash returns and Return on Equity. Fundamental valuation begins with an understanding of the percentage return you should be seeking in a real estate asset, given the risks associated with that investment. Buying an asset at the right price has a tremendous impact on the success of your investment. Paying too high of a price and relying on unrealistic growth assumptions to rationalize a purchase will inevitably lead to a loss of investment. October 2010 The author, Dan Pryor, is a partner at Odessa Realty Investments, LLC. Mr. Pryor has twenty-two years of cumulative experience in real estate investing and investment banking. He has dirt experience in numerous aspects of real estate, including acquisitions restructurings, repositioning, and property management. His past investments and property management include office, multifamily, retail, recreational and medical properties. Mr. Pryor also has an institutional financial background as an investment banker with Lehman Brothers and Salomon Smith Barney (now Citigroup). Mr. Pryor graduated from Middlebury College and the Yale School of Management (MBA). 5 Odessa Realty Investments, LLC

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