Playing the Cap Rate Game: Buyers Beware


There are a handful of ways to increase the value of an income producing property.  Some are within the control of the owner, some are not.  The problem is that in many instances, tremendous value has been created over the past five years through artificial means.  A change in global economic conditions or federal fiscal policy may wipe out billions of dollars in value and send scores of buildings into bankruptcy, foreclosure or restructurings.

Throughout this article we will refer to some simple financial examples to illustrate how value can be created (or lost).  We will assume that we have a 100,000sf office building that is 80% occupied, the gross rent is $32/sf which includes operating expenses and real estate taxes of $12/sf.  We will also assume that 10 year Treasury Rates are 2.75%.  Finally, we will assume that this building was recently purchased for $20,000,000 (representing an 8% cap rate on the $1,600,000 of net operating income).

Investors looking to acquire an income producing property will typically apply very complicated discounted cash flow analyses to the asset based on their assumptions about the future.  A more simple approach and one that is often used after the fact to benchmark a purchase is to apply a “cap rate” to a property’s net operating income.  “Net operating income” is generally defined as the gross rentals (in our example, 80,000sf at $32/sf) less the costs of operating the asset (i.e., 80,000sf at $12/sf).  The cap rate is essentially the buyer’s required rate of return on the real estate investment based on the perceived risk as compared to a risk free investment such as U.S. Treasury Bills.  Thus, in our example, based on the fact that the owner could earn 2.75% on U.S. Treasury Bills with virtually no risk, he required a premium of 525 basis points over the Treasury rate (the “spread”) to compensate for the relative risk of the real estate investment (i.e., 2.75%+5.25%=8.0%).  Because the building in our example is generating $1,600,000 in net operating income ($32-$12)/sf x 80,000sf), the buyer could pay $20,000,000 for it and achieve his 8% required return.  Thus, Price =NOI/Cap rate.

How are cap rates determined?  Part of the cap rate is based on the “risk free” rate in the market (i.e., prevailing Treasury rates) and the balance is based on the buyer’s perceived risk in the particular investment as compared to the risk free rate (the “spread”).  Thus, cap rates will generally rise as Treasury rates rise and fall.  The “spread” between the risk free Treasury rate and the required return on the particular investment is more subjective.

The fact is, different investors have different risk tolerances and may also differ on their assessment of the challenges facing a particular building.  A buyer who believes that a large tenant will renew its lease in two years may require a lower cap rate for the investment (i.e., will be willing to pay a higher price) than someone who is certain the tenant will leave.  Among the factors that can impact perceived investment risk and, therefore, the required cap rate are: the type of building (i.e., office, industrial, multi-family, hotel, etc….), the amount of current vacancy in the building or risk of future vacancy, the credit of the current tenants, the existence of deferred maintenance, the quality of the neighborhood, the existence of competing product nearby and local demographics.  Thus, while in today’s world, multi-family apartments generally trade at a lower cap rate than office buildings, a vacant apartment project in a bad neighborhood might very well trade at a higher cap rate than a trophy office building in New York City which is 95% occupied by investment grade tenants.

Given the foregoing valuation formula, there are several ways that an owner can proactively impact the value of its asset.  In our example, if the landlord can either increase the rents by a dollar or reduce operating expenses by a dollar, the value of the property would go up by $1,000,000 all else remaining equal ($80,000/.08).  Alternatively, if the owner could find a way to lease up the remaining 20,000sf at the same $32/sf, he could increase the value of the building by $5,000,000 ($32-$12)x20,000/.08).  All of these value enhancements require proactive investment, marketing or repositioning by the owner.  However, tremendous value can also be created or lost purely as a result of federal monetary policy which is completely out of the control of the owner.

Lots of people have made money in real estate as we continued into a declining interest rate environment simply by playing the cap rate game; buy in a high interest rate/cap rate environment and sell when interest rates/cap rates decline.  If 10 Year Treasuries were to fall further to 2.25% but all else remained equal, the owner in our example could theoretically sell the building for $21,333,333 ($1,600,000/.075) or a $1,333,333 profit, without ever increasing rents, reducing operating expenses or increasing occupancy.

Many landlords today are worried because we are in uncharted territory as far as interest rates go.  Because the Federal Reserve has artificially kept interest rates at effectively zero, cap rates, which are tied to interest rates, are at historic lows (meaning buildings are trading at historically high multiples).  Further, because investors today are desperate for yield, many are accepting smaller risk premiums than they would normally demand.  Thus, while a 4.8% cap rate on an apartment building may seem like an inadequate risk adjusted return; it’s a lot better than 2.75%.

Assume that the Federal Reserve decides to pull back from their recent monetary policies and allow interest rates to rise.  If 10 year Treasuries rise to 4.75%, the owner in our example would suffer a major loss even though he’s still getting his $32 rents and hasn’t allowed expenses to rise.  A sale at a 10% cap rate (4.75% plus the 525 basis point risk spread) would yield a total sale price of only $16,000,000.  If, instead of selling the asset, the owner sought to refinance the asset with the lower valuation, the owner may be required to put more equity into the property depending on how much of the original debt had been amortized.

A lot of investors today bought assets at very high prices given the historically low interest rates and, therefore, low cap rates.  In many cases, investors seemed like they were creating value through smart property management when in reality they were simply taking advantage of declining interest and cap rates.  However, many people believe that interest rates (and, therefore, cap rates) cannot be artificially depressed forever. Eventually they must rise.  Given the new Fed Chief and the uncertainties of our global economy, many real estate investors are worried about the future.  Despite well designed marketing plans, well thought out capital improvements and a strengthening economy, millions of dollars in real estate value may be wiped out if interest rates rise.  If and when that happens, tenants may find both trouble and opportunity.

For more information contact Glenn Blumenfeld

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