Capitalization Rates in a Turbulent Market
I often get calls from commercial real estate lenders asking me what the current capitalization rate is for a particular property, as if cap rates are monolithic numbers that one simply picks from a chart, or off a tree.
Contrary to public opinion, capitalization rates are not set in stone, but rather are fluid, like financial markets.
Simply put, a capitalization rate can mean many different things to many different people, depending on their perspectives.
From the borrower's perspective, if the property being considered for purchase generates a net annual operating income (NOI) of $120,000 and the expected annual rate of return is 9%, one may be willing to pay as much as $1,333,333 for that property ($120,000/.
09=$1.
333MM).
This rate would be considered a "going in" capitalization rate, as it is applied to the first year NOI, which may or may not be the stabilized year's income stream, or the full income potential of the property.
Consider, if you will, that in the same example above, the $120,000 in annual rent was derived from tenants whose rental rates were all 20 percent below market rent.
Consider also that the new buyer will have the opportunity to increase all the rents in the building by at least 20 percent by the second year of ownership, due to lease expirations, or contractural rental rate increases, as noted in the lease agreements.
A 20 percent increase in the NOI would increase the value of the property from $1,333,333 to $1,600,000 assuming that the same 9 percent capitalization rate is applied.
The implied capitalization rate, then, at the time of purchase, could be as low as 7.
5 percent if the buyer paid $1,600,000 for the property based on the first year NOI of $120,000.
Again, it is all about perspective and the desired returns on invested capital.
In this example, the buyer may very well end up with a 9% annual rate of return, though a year may need to pass in order to realize that result.
The added benefit to real estate returns is not only in the cash flows from the rental income, but also on the appreciation of the asset over time.
When real estate markets are appreciating, investors may be willing to sacrifice a lower initial rate of return in the hopes for a larger payoff down the road, when the asset is finally sold and the reversionary value is realized.
The capitalization rate applied to the net operating income at the end of an investor's holding period is called the terminal capitalization rate.
For example, if the net operating income in year 11 of the holding period is $300,000 and the reversionary value prior to discounting is $2,400,000 the terminal capitalization rate is 8%.
One investor's "going in" capitalization rate (the buyer), is another investor's "terminal" capitalization rate (the seller).
When an appraiser prepares a discounted cash flow analysis of a property, they will analyze the cash flow for each year of the holding period, and apply a terminal capitalization rate to the cash flow in the year after the anticipated sale date.
The periodic cash flows are then discounted back to a present value, and added to the discounted value of the reversion (after deductions are made for selling costs).
The discount rate is based on the time value of money concept, and the "return of" and "return on" invested capital.
These are complex financial concepts, which we can discuss in future articles.
The point of this article was to shed some light on the concept of capitalization rates in turbulent or volatile markets.
As investors of all kinds scramble to stash their liquid assets in safe investments, yield requirements often take a back seat to safety.
Government backed bonds become more popular than riskier investment vehicles, which force return rates down, initially.
As liquidity becomes more scarce, yield requirements for more risky investments rise.
Speculative real estate investment capitalization rates will likely rise, as investors go into "capital preservation" mode.
Strained financial institutions become more stringent with their credit policies, and the costs of borrowing money also rise.
Since rates of return on real estate investments must consider both the return on invested capital, and the return of borrowed capital, the total return will eventually need to be higher in order to attract investment.
This desire from the investment community to be rewarded more handsomely for taking on greater risk, results in rising capitalization rates on some real estate investments.
There are exceptions however, such as credit tenant deals in which the strength and creditwothiness of the tenant determine risk, though corporate bonds will also be more risky in turbulent or extremely volatile economic cycles, and perceived risk becomes real risk when a buyer and seller agree on price.
Contrary to public opinion, capitalization rates are not set in stone, but rather are fluid, like financial markets.
Simply put, a capitalization rate can mean many different things to many different people, depending on their perspectives.
From the borrower's perspective, if the property being considered for purchase generates a net annual operating income (NOI) of $120,000 and the expected annual rate of return is 9%, one may be willing to pay as much as $1,333,333 for that property ($120,000/.
09=$1.
333MM).
This rate would be considered a "going in" capitalization rate, as it is applied to the first year NOI, which may or may not be the stabilized year's income stream, or the full income potential of the property.
Consider, if you will, that in the same example above, the $120,000 in annual rent was derived from tenants whose rental rates were all 20 percent below market rent.
Consider also that the new buyer will have the opportunity to increase all the rents in the building by at least 20 percent by the second year of ownership, due to lease expirations, or contractural rental rate increases, as noted in the lease agreements.
A 20 percent increase in the NOI would increase the value of the property from $1,333,333 to $1,600,000 assuming that the same 9 percent capitalization rate is applied.
The implied capitalization rate, then, at the time of purchase, could be as low as 7.
5 percent if the buyer paid $1,600,000 for the property based on the first year NOI of $120,000.
Again, it is all about perspective and the desired returns on invested capital.
In this example, the buyer may very well end up with a 9% annual rate of return, though a year may need to pass in order to realize that result.
The added benefit to real estate returns is not only in the cash flows from the rental income, but also on the appreciation of the asset over time.
When real estate markets are appreciating, investors may be willing to sacrifice a lower initial rate of return in the hopes for a larger payoff down the road, when the asset is finally sold and the reversionary value is realized.
The capitalization rate applied to the net operating income at the end of an investor's holding period is called the terminal capitalization rate.
For example, if the net operating income in year 11 of the holding period is $300,000 and the reversionary value prior to discounting is $2,400,000 the terminal capitalization rate is 8%.
One investor's "going in" capitalization rate (the buyer), is another investor's "terminal" capitalization rate (the seller).
When an appraiser prepares a discounted cash flow analysis of a property, they will analyze the cash flow for each year of the holding period, and apply a terminal capitalization rate to the cash flow in the year after the anticipated sale date.
The periodic cash flows are then discounted back to a present value, and added to the discounted value of the reversion (after deductions are made for selling costs).
The discount rate is based on the time value of money concept, and the "return of" and "return on" invested capital.
These are complex financial concepts, which we can discuss in future articles.
The point of this article was to shed some light on the concept of capitalization rates in turbulent or volatile markets.
As investors of all kinds scramble to stash their liquid assets in safe investments, yield requirements often take a back seat to safety.
Government backed bonds become more popular than riskier investment vehicles, which force return rates down, initially.
As liquidity becomes more scarce, yield requirements for more risky investments rise.
Speculative real estate investment capitalization rates will likely rise, as investors go into "capital preservation" mode.
Strained financial institutions become more stringent with their credit policies, and the costs of borrowing money also rise.
Since rates of return on real estate investments must consider both the return on invested capital, and the return of borrowed capital, the total return will eventually need to be higher in order to attract investment.
This desire from the investment community to be rewarded more handsomely for taking on greater risk, results in rising capitalization rates on some real estate investments.
There are exceptions however, such as credit tenant deals in which the strength and creditwothiness of the tenant determine risk, though corporate bonds will also be more risky in turbulent or extremely volatile economic cycles, and perceived risk becomes real risk when a buyer and seller agree on price.
