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A Beginners Guide to Property Valuation Using Capitalization Rates

There are multiple ways to value a property. The most popular methods are (1) income method, (2) comparable property sale method and (3) replacement cost method. The most fun of all and the one that can be used in any situation, including a recession is the income method. The best way to value properties is by capitalization (cap) rates. Capitalization rates are often controversial and misunderstood variables in commercial real estate valuation equations. To value properties, most buyers and sellers prefer an income approach, which analyzes cash flows to determine debt service and investor return typically the internal rate of return so it's easy to see why cap rates are scrutinized. In fact, no other valuation aspect is debated as heavily as cap rates because unsupported data often lead to inaccurate commercial property valuations.1 As a general rule, the higher the risk, the higher the anticipated return.2 When cap rates in Los Angeles are at 6.5%; its common for cap rates in Salt Lake City to be much higher at, say, 7.5% to 8.5%. In its most simple form, cap rates turn income into value and have an inverse relationship to that value. This briefing article will attempt to cover cap rates in the following 3 areas: 1. Factors that influence cap rates 2. Property valuation using cap rates 3. Backing Into a Property Value price to maintain that yield. Adjusting your yield based on your cost of capital is an evaluation called the overall cap rate. Tenant Quality. Tenant quality plays the biggest role in determining which cap rate to use when valuing a property. There is an inverse relationship between tenant quality and cap rates. An investor purchasing a building with a very low-risk tenant like McDonalds or Chase Bank for example, would expect to pay a premium for the property assuming other important factors like lease term, and building quality are in order. On the contrary, an investor purchasing a building with a local jeweler or local car wash user would be taking a higher risk and thus would expect a higher return or cap rate in exchange for taking that risk. Another important quality to analyze is how many tenants there are. This can be a matter of preference as more tenants can also mean more management expense and tediousness. Some investors consider buildings with more tenants a lesser risk much like a securities investor may prefer mutual funds over a single stock. Length of Term. One of the formalities of investing in a commercial investment property would be a nice long lease term. In the commercial real estate investment world, a 5-year lease term for the tenant is as low as you would ever want to purchase and for obvious reasons. You are purchasing the property based on the promise of the future revenue stream it will provide and you dont want that stream to dry up in one or two years; as a general rule; the longer the tenants lease term; the lower the cap rate/risk. Building Quality. It goes without saying that the property purchased should be well kept, pass a commercial inspection and be free of any deferred maintenance. Leasing Market Status. Another factor to consider when assigning the proper cap rate to ascertain the right value is leasing market. Even if the investor gives a passing grade to all the factors above; the quality of leasing market will affect the cap rate. In

Factors that influence cap rates


From a beginners prospective, there are six factors that influence cap rates including interest rates, tenant quality and number, length of lease term, quality of building, leasing market status and other miscellany. Interest Rate. When interest rates go up or down you will generally find cap rates adjusting in the corresponding direction. Another way to think of this is; if your cost of capital goes up and you are expecting a certain yield, then you must purchase the property at a higher cap rate or a lower purchase

other words if there was a beautiful building leased by the Social Security Administration office located in the depressed market of Crescent City, CAthe tsunami capital of America and rundown logging communityan investor would have to ask the question, In the event the government vacates this building, how likely is it that I will find a comparable replacement tenant, thus preserving my initial investment? If the prospects for replacing the tenant are poor, this would have an upward pull on the cap rate and a downward push on value of the Table 1 property. Miscellaneous Items. There are an untold number of additional factors influencing cap rates and values. Some of these Taxes include: Negotiated annual Insurance escalations in the lease, a Common Area Maintanance reasonable price per square Sewer Water foot based on comparable vacant sales, financial ratios Garbage Gas & Electricity of the tenant, corporate guarantees, etc... The assigned cap rate could even Total Operating Expenses Net Operating Income be influenced up or down based on what you had for Less Vacancy Factor (5%) breakfast that morning or what everyone else is doing. Less Res. & Maint. (2%) The herd mentality works in Adjusted NOI Market cap rate property markets as it does Value on Wall Street with highly educated and successful individuals following the pack as was recently experienced by investors in the Madoff funds. A trigger or precipitating event can start the herd moving.3

for market vacancy and reserves and maintenance. Generally, in a multi-tenant property purchase that is financed, the bank will force a vacancy factor into the sale; generally this is equal to the current vacancy of the market or a bit less. In addition, every prudent commercial property owner should be retaining a small percentage of its revenue for unexpected repairs and maintenance; or just to have extra cash on hand in the event of a prolonged vacancy. This is called a reserves and maintenance account and it is generally 2-3% of NOI. Now that the adjusted NOI has been calculated; divide the market cap rate you are using 123 Park Place (derived from the factors 20,000 Building Square Footage referenced above) by the NOI. 1.75 $ Full Service Lease Rate/sf A spreadsheet of this exercise 420,000.00 $ Gross Rental Income YR#1 can be found in table 1. ----less operating exp.
$ $ $ $ $ $ $ (30,000.00) (5,000.00) (6,000.00) (600.00) (400.00) (1,200.00) (32,000.00)

Backing Into a Property Value

The most common method of valuing commercial property is the comparable method. This (75,200.00) method takes comparable sales $ that have occurred within the 344,800.00 $ recent past, generally 6-months (17,240.00) to 1 year, and compares them to $ (6,896.00) the subject property. Generally, $ there is an upward or 320,664.00 $ 7.5% downward adjustment based on $ 4,275,520.00 fact finding during the appraisal. This is a reliable method; however, it can be difficult to practice this method in a recession. In a recession it is possible that each sale included one or more of the following disqualifications, if not others: . Duress on the part of the buyer or the seller; . Lack of relevant knowledge on behalf of either; or . Someone who acted imprudently.4 During The Great Recession, actual sales of commercial properties have become an infrequent event. It can be difficult to find the occurrence of sales period, let alone comparable sales. With the knowledge of property valuation using cap rates, an agent or appraiser can determine the market lease rate of the property, subtract out operating expenses to reach the appropriate NOI and divide by the cap ratethis is called backing into a property value.

Property Valuation Using Cap Rates


The formula for finding market value using a cap rate is: NOI Cap Rate = Value. In order to find the value of a property using a cap rate you must first find the Net Operating Income (NOI) of the property. The Net Operating Income is found by taking Gross Rents and subtracting out all operating expenses. The sellers debt service and depreciation are not included in the operating expenses. It would also be wise to exclude management fees in this calculation because the prospective buyer will likely have a different management approach. Once you arrive at a suitable NOI number, is your work complete? No, now you need to adjust the NOI

While commercial sales may be few and far between in todays economy, leasing data can be found in abundance due to the fact that many businesses are less likely to qualify for a loan with todays strict loan underwriting policies. This situation doesnt seem like it will change because falling asset prices is a big problem for commercial landlords and their bankers.5 Thus, developing a working knowledge of property valuation using cap rates will ensure that you can quickly arrive at a reliable market value regardless of comparable sales data. Sources:
1. John Simpson, Cap Rate Follies, CIRE Investment Magazine, accessed February 14, 2012 http://www.ccim.com/cire-magazine/articles/cap-ratefollies 2. Jeffrey Dunne and Patrick Bisceglia, Capitalization Rate Arbitrage: Trading future upside for current yield, accessed February 14, 2012, http://www.northeastrebusiness.com/articles/MAY07/fe ature3.html 3. David Wyman, Maury Seldin, Elaine Worzala, Richard H. Pennell, A new paradigm for real estate valuation? Journal of Property Investment & Finance Vol. 29 No. 4/5 2011 pg. 341-358 4. John Dorchester, Jr. Market Value, Fair Value & Duress, page 7, the journal of property investment and finance Vol. 29 No. 4/5 2011 pg. 428-447 5. Megan McArdle, Capitalist Fools; commercial real estate is dominated by professionals, not hustlers looking for a quick flip, so why is the market about to melt down? Atlantic Monthly Jan-Feb 2010 pg. 28-30

Mike Ash, Investment Specialist

Ash.

When I want to protect my cash; I use Mike

Mike Ash
1500 Country View Drive Modesto, CA 95356 (209) 968-1998 mash@prucommercialre.com

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TO: Harrison Miller FROM: Mike Ash DATE: April 23, 2011 SUBJECT: Strategy--Crown Electrical Supply (CES) I reviewed the actual 2005 and 2006 financials submitted by Mr. Mike King this morning. Please review the following analysis and recommendation moving forward for Commercial Bank of Utah: Analysis: Profit Margin: With the huge increase in sales one would think that Crowns management team would be able to at least keep the profit margin stable, if not increase it. In this case however, it appears that Crowns increase in sales has taken it by surprise and it finds itself unprepared to capitalize on the opportunities presented by this housing boom caused by sub 6% interest rates. Crowns profit margin has actually decreased from 4.4% in 2005 to 4.2% in 2006, which to me denotes operational inefficiencies in the company. Accounts Receivable Collection Period: This seems to be a bright spot on the financials for Crown. Accounts Receivable Collection Period has decreased from 23 days to 20.3 days from 05 to 06 meaning Crown is getting paid nearly 3 days quicker from one year to the next. Inventory Turnover: this ratio has gone from 4.6 times/year in 05 to 4 times/year in 06. This represents a significant problem as found in the homework assignment for chapter 5. If Crown had maintained the 05 ratio all the way into December of 06 it would have an extra $52,317 in cash in the bank. This exposes the fact that Crown is keeping its inventory on hand longer, tying up funds unnecessarily in its inventory account. Moving forward, I would recommend that Mr. King decrease his inventory, which would increase his inventory turnover and free up cash. There are clearly enough inventories available for him to continue servicing his clients, while reducing inventory and freeing up cash to make his loan payments. In the short run this is probably an acceptable measure to take if Mr. King has interest. Accounts Payable Period: Accounts Payable is a bit out of control from 05 to 06 and I would be concerned about Mr. Kings ability to maintain strong relationships of trust with his suppliers. Accounts Payable Period has increased from 19.4 days in 05 to 42.5 days in 06, which is a

dangerously high level. This must be brought in line as soon as possible to protect Mr. King and Crowns reputation with his suppliers. There are multiple electrical supply companies out there vying for the same business in this hot real estate market and no one really has to do business with Crown. In order to reduce the accounts payable period Crown might consider slowing down its sales to a level where it can manage its inventory and its cash more efficiently. He could do this by decreasing his AR policy, but that would mean he would be losing business because builders like to have a little leeway when it comes to paying for materials for a job. Current Ratio: Crowns Current Ratio has decreased from 6.1 days to 2.4. Clearly Crowns current liabilities have grown too quickly in relation to its current assets. This issue could be dealt with by reducing inventory like I discussed above. Obviously a major reason for Crowns increase in liabilities is its increase in notes payable due to the new building it constructed and we cant fault them for that because we were the ones who approved the loan in the first place. Recommendation: It appears Crown is operating a strong business sales-wise and that this business is a good risk for our firm to take. I would recommend making a new $50,000 loan to Crown at 5% interest for 3 years. Doing this is a bit of a risk for our bank because Crown s current Debt to Equity ratio is 38.43% and has increased from 13.43% in 2005. If we were to make a $50,000 loan to them their debt to equity ratio would go up to 45% and that makes me a bit nervous. I think 40% is the maximum amount that this company should finance themselves with debt but because their sales are so strong and they are growing, I think this is a reasonable risk to take. In addition, whoever did the underwriting for the original loan should be terminated immediately for not recognizing the growth that Crown would have in this market and not recommending that we increase the loan amount in the first place taking advantage of the higher 6.25% rate. Making this new loan would be contingent upon Crown lowering their accounts payable back to 2005 levels and increasing its inventory turnover back to the 2005 level as well (4.6). In addition to this recommendation, one way that Crown could free up capital in this vibrant real estate market is to do a sale lease back in its building. They could even lower their monthly cost by signing a lease with themselves that is at below market rents. This would provide significant cash infusion for them. For example, the market rate for new high-image Industrial Warehouse space in the Utah County market is .55/sf NNN. If we make the assumption that Crowns new warehouse is 4,000sf we would generate a net operating income of (.55X4,000) $2,200/month or $26,400 per year. If we use a market capitalization rate of 7.5% we reach a market value of ($26,400/.075) $352,000 for the building. After paying off the loan ($75,000), commissions ($21,120), and closing costs of 1% ($3,520) Crown would come away with $252,360 in cash from closing. This is a very common practice for companies looking to increase cash flow in the short term and would provide a reset so to speak for Crown to settle

into its increased level of sales and manage its cash more effectively starting now. Because of the debt to equity ratio discussed above I would recommend this option first if they were willing to sell the new building. If they are not willing then we issue the new loan. I also noticed in the lesson material that Mr. King buys donuts. Im guessing this is a regular occurrence and that hes hiding these donuts in Miscellaneou s Accruals. If we make the assumption that Mr. King buys donuts every working day (260 days/year) at an avg. price of $5.00/dozen donuts, he is literally wasting $1300/year on these tasty treats. I would recommend adding the elimination of this expense as a contingency in the new loan covenants should we decide to grant Mr. King a new loan moving forward. Recapitulation of recommended options: 1. 2. 3. 4. Decrease Inventory to come up with the $25,000 loan payment on January 31, 2007 Issue a new 50,000 loan at a 5% interest rate and a new 3-year term Liquidate the company or slow sales Take advantage of the excellent real estate market and low cap rates in a sale-lease back 5. Eliminate senseless donut consumption and other Enron-like accounting principles Best Regards, MA

See Part II of this assignment below:

Part II: For each paper identify which emphasis learning outcome or outcomes the paper addresses.
Paper #1: A Beginners Guide to Property Valuation Using Capi talization RatesThis paper addresses proper communication skills in the form of a typical magazine article format. It addresses the critical principles taught in MCOM 320. It encompasses a good use of font, color, white space, critical analysis, and good content. With all of those items aside, it also provides a nice analysis of capitalization rates, which is a financial tool for valuing real estate based on income. It also has principles of marketing with the key concepts of price and location being discussed in great length. Paper #2: Case Study Paper for Chapter 9 of Bus M 300Financial ManagementThis paper is all about the inexact science of financial analysis by utilizing financial ratios. Each financial ratio had to be computed from multiple years of financial statements provided by a small Utah based company. Once the ratios are computed for each year; assumptions were made and a final recommendation was made. The paper was formatted as a memo. It proposed an imaginary scenario as if I was the financial manager of the Bank analyzing whether to extend further credit to the subject company/borrower, Mr. King.