Is the property you're about to buy really performing as advertised?
There are many definitions of what a capitalization rate is in this industry, but here's mine: "It is the unleveraged yield of an income producing asset within the first year of operation, calculated by dividing the market value from the net operating income.
Net Operating Income / Asset Market Value = Cap Rate
Before we get too far, we need to determine the net operating income and how that is derived from our cashflow analysis. To put it in simple terms, it is the property's income minus the operating expenses (ie. insurance, maintenance, landscaping, etc).
Net Operating Income
Note that the operating income does not take into account any debt service or tax implications to the investor. Those are separate from the operation of the asset. What you'll notice is that these seem like pretty straightforward calculations, so how do investors get it so wrong, so often? It's not entirely their fault as these calculations can be manipulated by sellers and brokers to get a higher sales price. So here's a breakdown of the most common problems I see.
#1. Cap Rate is Based Upon the Wrong Year's Cashflow
When you are purchasing a property, is the cap rate based upon the previous year's NOI or the next year's NOI? Before you answer that, think about what you're buying. If you're buying an income producing property, you are buying the income that it produces once you've purchased it. With that thought process you can understand that the NOI and subsequent cap rate that's based upon should be the next 12 months income after you've purchased the property. Yet despite this, I will often see on a flyer, the NOI from the previous year and the cap rate based upon those figures.
#2 Cap Rate is Based Upon Proforma Numbers
"Proforma" is a term used in commercial real estate to attempt to define projections some time in the future. For example, many times you'll see an offering memorandum that shows cashflow projections based upon proforma numbers, meaning that they are based upon some sort of increase in rents or decrease in vacancy. The real problem that most investors face, is how do you know if those numbers will come to fruition? If the proforma is based upon leasing up more of the building, why hasn't the owner already done that? What happens if the rental increases are projected to occur in a down market? My opinion is that you never buy an income producing asset based upon someone else's projections. Remember that they are incentivized to fudge the numbers!
#3 Cap Rate is Based Upon the Wrong Expenses
This one is probably the most common manipulation I see in the market. One of the line items in a property's expenses is "real estate taxes", which also happens to typically be the largest expense you have. What we see often is that the RE tax expense is based upon the current owner's tax obligation. But what happens when the sale occurs? One thing we know is that taxes almost never go down, and in fact rarely stay the same! Most often the property is reassessed upon sale and property taxes can increase substantially. Make sure any NOI calculations are based upon the reassessed taxes after the sale. This can usually be accomplished by contacting the county assessor's office or using an online tax calculator.
#4 Purchase (offer) Price vs. Value
You'll notice in the calculation above that the NOI is divided by the market value, but that is not always representative of the purchase or offer price. Good deals and bad deals abound, and can sometimes be disconnected from market value. An appraisal or BOV ("Broker Opinion of Value") can often help you determine the pricing in the current market. Ensure that the cap rate yield is indicative of what the market is supporting.
Capitalization Rate is a common term used in commercial real estate investing, but often the most misunderstood. Make sure you are using the correct calculations and not simply trusting someone else's mathematics. If you have questions regarding any of this, reach out to a trusted commercial real estate advisor to ensure you're not the one being manipulated!
About the author:
Michael Hironimus, CCIM is the Certified Investment Advisor and Principal Broker for Duckridge Realty specializing in commercial real estate investment portfolios for high net worth clients and institutions, focusing on market, financial and risk analysis. He is also a faculty instructor for the CCIM Institute, teaching professionals globally in the CI-102 Market Analysis Core Course.
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