Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.
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37 March | April | 2015 CCIM.com Marketplace Misuse? Common reasons for cap rate variations of en come from the income stream and operating expenses used in the rate's extraction. Failure to consider the likely future income of the property (year one pro forma) does not follow the principal of anticipation. T e historical and current operating data is useful when developing a projection of year one data, but should not be used in the extraction of a cap rate when applying it to year one projections. Extracting a cap rate from market data using historical income and applying it to the year one projection of the property being valued will result in an incorrect value opinion. Real estate is of en considered a hedge against inf ation due to the ability to increase rents at or above the rate of inf ation. In an upward trending market the buyer of a property is expecting next year's income (year one) to be greater than the trailing year to account for appreciation. Extracting a cap rate from the in-place income (less risk) and applying it to the future income projection (more risk) will overvalue the property. In addition, the same method of income and expense projections used to extract a cap rate from the market should be used to value a property. Using a dif erent income stream from a comparable property (not stabilized, no third-party management, no replacement reserves, under market operating expenses, and such) will result in a dif erent risk prof le of the income stream and corresponding cap rate. Many market participants do not include replacement reserves as an above-the-line (net income) expense when developing cash f ow projections. Replacement reserves for future capital expenditures are market specif c. Including or excluding replacement reserves will have an impact on the cap rate extracted from the sales transaction, but not the value of the property. Neither method is incorrect as long as the same method is applied to the property being valued and the sale comparable. If the sale comparable does not include replacement reserves in its pro forma projection, and the subject does include replacement reserves in its year one projection, the market extracted cap rate must be adjusted downward to ref ect a riskier income pro- f le of the sales transaction comp when compared to the asset being valued. If no adjustment to the cap rate is made, then the subject will be undervalued due to dif ering risk prof les. Properties that do not include replacement reserves have increased risk due to the lack of a sinking fund for future capital expenditures. In other words, the NOI needs to be "clean": One cannot compare an NOI with deducted reserves above the line with one deducted below the line. Owner-Managed Properties Another common misconception concerns third-party management fees. Small properties or ownership entities that have a built-in man- agement company of en do not include third-party management fees in their pro forma. Having a third-party management company man- age an asset may reduce the operational risk of the property and can result in a lower risk prof le of the future income stream. A lower risk prof le results in a lower cap rate. Table 1 shows how excluding third- party management fees impact the year one return and risk prof le. As Table 1 reveals, a 7.5 percent cap rate is appropriate if the prop- erty pro forma includes expenses for third-party management fees. Based on the projected NOI and market extracted cap rate, a value of $1,666,667 is indicated. If the same property does not include man- agement fees in the pro forma projection, the value of the property is unchanged, with the risk adjusted cap rate increasing to 8.1 percent. T is is why it is necessary for potential buyers to reconstruct NOI to include such items as property management. T e increase in the cap rate is to account for increased risk due to the lack of professional third-party management. Additionally, real estate is considered to be a passive investment with the opportunity cost of the owner's time requiring compensation through a management fee or higher rate of return. Expense Comparison in Sale Comparables Comparing the operating expenses used in a sale comparable to extract a cap rate is a good indicator if the cap rate is market driven. A sale comparable that is owner managed and does not include reserves will have below-market expenses on a per unit comparison (percent- age of ef ective gross income, per square foot, per unit, and such). A comparison of the expenses from the sale comparables to industry standards used in the local market will allow the analyst to adjust the extracted cap rate accordingly and then apply the revised cap rate to the property being valued. If a data set of comparable sales indicates a wide range of cap rates, then it is likely that one or more of the sales is not based on market derived income and expenses. Impact on Property Valuation Table 2 shows how various income and expense projections can impact the extracted cap rate and the asset's value indication. For purposes of this analysis, only one variable has been adjusted. In actuality, a sale comparable will of en have multiple variables that need to be adjusted in order to accurately extract a cap rate. T e Table 2 example reports a market extracted cap rate that ranges from 5.70 percent, based on the asking price commonly quoted by brokers in third-party surveys for marketing purposes, to 6.48 percent, based on using year one projections. All of the extracted cap rates are correctly calculated. However, the dif erence in rates is attributed to varying risk prof les of the income stream. Based on the provided example, adjusting just one variable can result in a 13.68 percent dif er- ence in value. If additional variables are included, the spread between the cap rates can widen and further magnify the miscalculation. Table 1: The Effect of Management Fees on Cap Rates Management Risk Profi le Net Operating Income Capitalization Rate (OAR) Value $10,000 Lower $125,000 7.50% $1,666,667 $0 Higher $135,000 8.10% $1,666,667