Steve Cary CPM®
This is where students struggle a little bit in the classroom, I think, it’s understanding this idea of cap rate.
Eric Storey CPM®
The capitalization process really means to convert future income into value. And one of the skills that our students have and we in the industry should have is to be able to value a property at the beginning of an investment, and be able to estimate the value of a property at the end of an investment. So to do that we have to have a going-in cap rate and we have to have a going-out cap rate. So Dave, maybe you can talk to me about how to develop a going-in cap rate.
Dave Domres CPM®
Well, there are a couple of methods to that going-in cap rate. I think historically, if we look at comparable sales in the marketplace.
Steve Cary CPM®
I think it is important to say that cap rates are market driven.
Dave Domres CPM®
Good point. Cap rates are market driven, so we look at the current marketplace and see if there are some comparable properties that have sold, understand what the price was and if there are any factors that affected the price, because every property has a lot of different details to that sales price. And then look and understand what the net operating income is, and if possible, what those cap rates on sales were.
There’s a lot of different strategies that can be used to develop the cap rate. If we only have one comparable, the question first would come forward, is that the most accurate comparable of a cap rate? Ideally, we find three or four or five.
Steve Cary CPM®
One’s not a big enough sample.
Dave Domres CPM®
One is not a big enough sample. So we try to find a representative average based upon some comparable sales and come up with the going-in cap rate. In the absence of that, there are two other methodologies that are used. There is the build-up cap rate method, where we use risk and liquidity as a component of developing a built-up cap rate. . .
Steve Cary CPM®
Somewhat subjective.
Dave Domres CPM®
Subjective, very subjective, because there are a lot of factors there that are individually driven. And then we have mortgage equity analysis, which takes the yield required by the lender on the debt and the desired rate of return by the owner on their portion of the equity to come up with an income capitalization rate that we apply to the current net operating income. Naturally, when you are looking at it over time, the question is, “What happens to that cap rate?”
Steve Cary CPM®
Yeah, what’s the relationship between the going-in and the going-out cap rate?
Dave Domres CPM®
If it’s a sale within a month, then the going-in cap rate is probably fairly representative of what’s happening in a month or six months, but once you start venturing out beyond a year, or two years, or in our typical scenarios where it is five or ten years, what do you see that affects that going-out cap rate over that period of time?
Steve Cary CPM®
You have to recognize that cap rate is a measurement of risk. I place risk on a property and I say, “How much risk am I willing to take?” I gotta have a reward to take risk. So the more risk I am asked to take, the bigger the reward I have to have.
What other factors influence going-out cap rate?
Eric Storey CPM®
The answer to that is a little complicated because capitalization, in my opinion, the cap rate is more than just a reflection of risk. The capitalization rate that we apply to a stabilized NOI is a rate that, if we achieve from just looking at the market, is seeing how people are buying properties and the relationship the sales price and the NOI. If people are buying properties in an area that they think are greatly appreciate, in value or in cash flow, then there’s more buyers that want to buy that property. And if there’s more buyers that want to buy the property, then competition raises the price. And so in hot markets or strong economic areas, cap rates will compress when there are more buyers coming into the market to buy properties. Hence, five or ten years later, in my opinion, the question is: How hot is the market? And are cap rates going up or down relative to people’s willingness to buy those properties at that time.
I do not personally believe that it is a reflection that if time has gone by there is risk, so the cap rate should be higher. I think cap rates in the future can be higher and I think they can be lower and I think they can be the same. Everybody knows there is risk over time but the elements that create cap rate can change for the positive or the negative.
Steve Cary CPM®
I disagree.
What do I do with going-in and going-out cap rates?
Dave Domres CPM®
So in summary, going-in and going-out cap rates are really what you quantify and justify.
Steve Cary CPM®
What if I neutralize the situation and make my going-out cap rate the same as my going-in cap rate?
Dave Domres CPM®
You’ve just justified it, but you provided me some support, some narrative, some analysis that says it is going to remain the same.
Steve Cary CPM®
Now there’s the key, to be able to provide support for the decision you’ve made.
Dave Domres CPM®
It’s all part of the overall recommendation.
Steve Cary CPM®
That’s what makes a student successful in the classroom – is to be able to communicate to the grader that he understands what this concept is by giving some justification for the decision they make.
Dave Domres CPM®
I agree.
Eric Storey CPM®
One of the key cash flows in IRR is terminal value. It’s key to have a correct cap rate going in and going out because that sets your value of when you sell, which affects your overall internal rate of return and NPV.
Steve Cary CPM®
That has way more influence than just the annual increases you might make in NOI, for instance.
I guess we could say it’s a key – setting a going-in cap rate and a going-out cap rate are essential skills that you should have in order to do a correct financial analysis of a property.