In Parts 1 and 2 on the Capitalization Rate, we discussed how the cap rate is utilized and how it’s calculated. In this final section, we’ll discuss the flaws in the cap rate and what its recent history and usage tell us.
1. What is the basic flaw in the use of the cap rate as a measure of return on a long-term investment?
The basic flaw in the use of the cap rate is its focus on a single year, whereas a typical income property investment is a multi-year proposition. Thus, you have to recalculate the cap rate for every year of the projected life of the investment. You basically are estimating NOI for each of those years as well as the projected value for each year; then, using the IRV formula discussed in Part 2, you calculate the return those numbers indicate by dividing the given year’s NOI by that year’s estimate of value for the property (R=I÷V).
2. In the middle part of the last decade, cap rates compressed to as low as 1% - 2%, while bond rates hovered around 5%. What motivates “sophisticated” investors to settle for such a low rate of return in an investment that’s as high risk as real estate?
To put that into perspective, here’s an example:
· A property is producing NOI of $250,000 and is acquired for a total purchase price of $10,000,000, or a cap rate of 2.5% ($250K ÷ $10M);
· Assume the purchase price represents $500 per square foot;
· The purchaser expects to sell the property within 2 years at a price of $650 per square foot.
Where is the investor’s real profit motivation?
Obviously, it isn’t in the cap rate during the operating years. It’s in the anticipated appreciation of $3,000,000 realized in the resale two years or less down the line. In other words, the investment expectation was to flip the property quickly for a profit sufficient to lift the overall rate of return as measured on the short life of the investment, such as by using a discounted cash flow method like the Internal rate of Return (IRR) method. Discounted cash flow analysis will be a topic of future postings to this blog.
In a red-hot or bubble real estate market like the mid-2000’s, this form of thinking is prevalent.
But then cap rates decompress (rise) back to historic norms, or higher. Why? Because when the bubble bursts, realization sets in that properties were overvalued. The market is uncertain where values will stabilize, so sales are few. Most sales in this situation are short sales or distress sales (bankruptcy, foreclosure), and don’t represent fair market value. Compounding the problem is the rising vacancy rate and increasing concessions to tenants due to business failures and the reduction in space needed by those tenants who survive by eliminating jobs.
The uncertainty revives the awareness of risk inherent in real estate investments, so the required rate of return increases accordingly. The greater the risk, the greater the required rate of return on invested capital.
In this kind of market environment some investors foolishly assume an ability to raise rent levels or cut vacancies or lower operating expenses or some combination thereof, which will increase NOI in future years; thus, increasing the rate of return. That, however, won’t happen because leases are binding contracts that span years regardless of changes in the property’s ownership; thus rents cannot be raised arbitrarily until the lease expires or is breached by the tenant
In the meantime, it’s good to remember that in past recessions the recovery of the commercial real estate sector consistently has lagged that of the larger economy. On a brighter note, effective rent should start to grow once job growth begins. When that occurs, then we should start seeing an easing of vacancies and tenant concessions in the marketplace. With the growth of NOI, values will start to rise, confidence and investor interest will be enhanced, and cap rates will begin to compress again.
At the moment, however, cap rates in the 5% to 5.5% range are seen only where the property is a core asset. These usually are well constructed, well-located, modern buildings enjoying 95% to 98% occupancy on long-term leases with very creditworthy tenants and located in gateway cities.
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©2011 by The Falbey Institute for the Development of Real Estate
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