Monday, June 14, 2010

Cap Rate Confusion

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

Brokers love cap rates. They are intuitive, easy to use, and there is no such thing as a “right” or “wrong” cap rate. What’s not to love?

Absolutely nothing, as long as you are mindful of the pitfalls of their use. Bear with me while I put on my pocket protector for a bit. From a valuation perspective, a cap rate is nothing more than the mathematical simplification of a perpetual discounted cash flow analysis under the assumption of constant growth in cash flows. Who cares? Well, investors should. And if investors care, so too should their brokers.

The reason that investors care is that a cap rates is not the same as investor’s return. To illustrate let’s look at a property that generates $100,000 in cash flow in year one. Let’s further assume that those cash flows stay constant (0% growth) for the next five years and the investor is able to sell the property for a 9.0% cap rate. Under this set of assumptions then the investor’s total return is 9.0%. Seems easy.

But most investments have some amount of growth in the cash flow stream (due to contractual rent bumps or increases in market rents). So what if the cash flows grow at 3.0% per year and then the investment is sold for the same 9.0% cap rate? The total return to the investor is 12.0% (9.0% cap rate + 3.0% growth). Again, pretty straightforward, but the total return that an investor earns is significantly different from our first scenario (9.0% vs. 12.0%).

Okay, but what happens if the sale cap rate (after 5 years) differs from our going-in cap rate? Let’s assume the same 3.0% constant growth, but rather than selling at a 9.0% cap rate we will assume that the building is sold at either an 8.0% cap rate, or a 10.0% cap rate. If the exit cap rate goes down to 8.0% the total return to the investor is 14.08% and if the cap rate increases to 10.0% then the total return earned by the investor is 10.21%. That is a considerable difference in investment performance.

Finally, what happens if the in-place rents are above market and after the first year cash flows decline by 15.0% and then grow by 3.0% per year thereafter (in light of what has happened to rents this is a very real situation). Let assume further that after the 5-year holding period the project is sold for that same 9.0% cap rate. Under this set of circumstances the investor’s total return is 7.47%

So under all scenarios presented the property was bought at a 9.0% cap rate on year-one cash flow. However, depending upon the assumptions we used for growth (or decline) in cash flows and the exit price the investor’s total return could be as high as 14.08% and as low as 7.47%. And this analysis excludes the use of debt which only magnifies the results.

So,”yes” cap rates are a nice easy tool to quickly compare initial yields between investments, but if you stop there you are not seeing the full investment picture. And it is the complete picture that most buyers of commercial properties should be concerned with.

No comments: