Thursday, February 4, 2010

Cap Rates- Real Estate and Risk

Capitalization (Cap) Rates have been around investment
real estate for a long time. Much longer than me. My
teachers taught that the Cap Rate is the key to determining,
and understanding, the value of an income producing
property. The formula for determining said value is
extremely simple, which is probably why I like it so much.

Income divided by Rate equals Value (or using an
acronym IRV)

The first key to this equation is knowing that Income means
net operating income (NOI). The NOI of a property is found
by subtracting from the actual income all of the expenses of
property ownership. These expenses include property taxes,
insurance, utilities, maintenance, management, cleaning,
repairs, snow and ice removal, landscaping, etc. It is important
to note that debt service, i.e. mortgage payments, are not part
of the equation in determining the NOI.

The not so simple part of this equation is the Rate. It is
really Cap Rate not Rate, but we just use the shorthand R for
Rate so that our acronym works.

The way I was taught, a cap rate should be an accurate
reflection of the amount of risk involved in the investment
real estate. The lower the risk, the lower the cap rate. Lower
cap rates make the V for Value in our equation higher. The
higher the risk, the higher the cap rate. Higher cap rates make
the V for Value in our equation lower.

What this means is that all cash flow streams are not
created equal.

It all made perfect sense to me. A forty year land lease
to McDonald’s has very low risk and thus should have a low
cap rate and a higher value in relationship to income. A beat
up old house converted to a four unit apartment in a
depressing neighborhood may generate lots of income, but
it is also fraught with risk and management issues,
thus it should have a higher cap rate which lowers the value
in relationship to the income stream.

If you have read previous posts, you may suspect that all this
verbiage is another attempt to lay out yet another cause of the
current mess in the real estate world. You are correct.

For the time period between 2001 and 2005 my business
partner and I became very confused by the investment real
estate market. We grew up with the idea that an 8% cap rate
was low, that a 15% cap rate was high, and that your basic
average real estate investment should be capped at 10%.
All of a sudden we were seeing cap rates at 7%. What was
up with that?

Since investors really make their money when they buy,
how were they going to make any money by overpaying so
much? For a while, we suspected that these were very smart
people who knew something that we did not. When cap rates
dropped to 6%, we suspected these were very smart people
who did not have a clue what they were doing.

The last two years should give indication about which one
of those suspicions was correct. Confirmation arrived
via e-mail yesterday.

Morgan Stanley Research, smart people if there ever were,
published their Commercial Real Estate 2010 forecast
paper back in early January. Such things take their time
getting to Newark. In their forecast is the following quote:

“Impact of interest rates on commercial real estate. Commercial
property cap rates are benchmarked to spreads over the 10-year

These are Wall Street people who live in a world that revolves
around securities; paper products with widespread market
acceptance like stocks, bonds, Treasuries, etc. Using their prism,
they have come to see real estate as a “security”. But… is
not a security. Real estate is bricks and mortar, sticks and steel,
concrete and glass, and dirt. It is fixed in place, tied to a
geography, subject to all sorts of risks and hazards that it cannot
escape from, plus its value is derived by its use over a long period
of time. The whole purpose of the cap rate is to judge the risks
and hazards over that time period. To benchmark it to anything is
to ignore the uniqueness of every real estate investment.

Smart people misjudged risk and thought that buying a real estate
investment was like buying a paper product. This led smart people
to pay way too much for, and more importantly borrow/lend way
too much money on, a whole bunch of real estate. We are enjoying
the fruits of those decisions now.

As a side note, in the calculation of value using a cap rate the whole
issue of financing is moot. Debt service is not part of that equation,
so interest rates and cap rates speak different languages.

We will talk about the impact of low interest rates and easy money
at a later date.

But for now, we add the mistaken assumption that real estate can
be valued and treated like a security as one of the many paths that
have led us to our current economic situation.

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