Donald Bouchard, CREIn the commercial real estate business you hear it all of the time. From the coffee machine to the board room, a key question is asked about a specific sale. So simple and direct, there must be a specific answer. And everyone seems to want to know. This knowledge is seemingly revered as the Rosetta Stone for understanding a recent sale and the broader commercial markets.
What was the cap rate?
Well…it depends upon whom you ask and how you ask the question. Paradoxically, you may get four different responses from four different sources with the good fortune of knowing that each answer is, in fact, probably right. Lest you think I am about to venture into deep metaphysical discussions or the possibility of parallel universes a la Stephen Hawking, it’s actually quite simple.
Capitalization rates in their simplest form are snapshots in time and simply reflect a basic relationship between price or value, and income. The derivation of a rate is a product of elementary school arithmetic after all. But when seeking the details of a transaction, the process is often not as simple. Compounding the verification of a specific capitalization rate is the need to more clearly define the variables. Price is usually pretty easy but even that can be complex as we all know. But assuming the price is not impacted by special financial considerations, or other factors, the key is to identify the income. Therein lies a potential trap for the unsuspecting.
Capitalization rates will differ for a given property depending upon how you or your source define the net income. Is it the “snapshot” net income at the time of sale? The forecasted 12 month “stabilized” income forecasted by the buyer, or the trailing 12 months? These three revenue streams can be very different indeed and reflect three distinct cap rates, all of which can have their basis in fact.
Now comes a more intriguing set of questions. While it is my view that the majority of rates tossed about by brokers and reported by parties to transactions reflect true net income levels, this is not always the case depending upon market conditions and property type. Did the income used to develop the rate include a deduction for reserves? Brokerage commissions? Tenant improvement allowances? Or as is most often the case, none of the above? These combinations can easily support the extraction of twelve different capitalization rates and each one may indeed be accurate in its own right.
The application of extracted rates to property being considered for acquisition, sale or financing purposes is a reasonable method provided that the rates match the income being capitalized. For example, you have information on five recent sales and have been able to confirm the timing and formulation of the income used to develop the cap rate, As long as you are applying it to like-kind revenues for the property you are evaluating, the results should be instructive. If, however, you develop cap rates from transactions where no “below the line” expenses such as commissions, TI’s or reserves have been deducted, it makes no sense to apply these rates to an income stream which then deducts these expenses to develop an NOI. Doing so can substantially undervalue a given property.
This is often a point of contention when the mystical and elusive “fee simple” value of property is required for ad valorem tax purposes. Should an appraiser take deductions for reserves, commissions and tenant allowances on a “stabilized” basis resulting in what can be a substantial reduction in net income available for capitalization? This depends entirely upon the cap rate chosen. If the prevailing cap rate for a given property type is 6.5% and reflects extractions from sales where the income capitalized did not include these deductions, then applying this rate to an income stream where these expenses have been deducted will undervalue the property.
Time and time again I hear the argument in tax cases that not deducting commissions and reserves is in error because an owner is always subject to these expenditures. My typical response includes the words no, Sherlock and one other in the middle there…but I digress. If you employ rates extracted from market evidence and all of the confirmed net income levels DO NOT include a deduction for these below the line expenses, do you really think the buyers ignored them in some massive mathematical delusion that befell the industry? I think not. But I remember years ago when the Massachusetts Appellate Tax Board correctly indicated in a specific case that the TI’s and commissions in their calculations were subsumed within the rate that they chose to apply. The SJC at the time, knowing essentially nothing about the intricacies of cap rate extraction and composition remanded the case to the ATB under the erroneous understanding that they had ignored the below the line expenditures. They flat-out failed to understand the concept adequately.
Do I mean to suggest that it is simply wrong to make these deductions? Not at all, but remember, if you apply the right rate to the appropriate revenue stream, you will be on solid ground.
Donald Bouchard, CRE is a senior vice president at Lincoln Property Company, Boston and is the 2016 chair of the New England Chapter of the Counselors of Real Estate.