Archives for September 2014

“If one is to be in real estate, commercial real estate is surely a nice place to live right now”

By: Bill Pastuszek, MAI, ASA, MRA , heads Shepherd Associates LLC, Newton, Mass.


Several surveys by major brokerages
contain statements such as,
“Investors are once again proving
that their confidence in commercial
real estate remains steadfast… a majority
of investors expect both core
fundamentals and property values to
continue to rise in the coming year.
That positive outlook is fueling a
desire to further expand real estate
holdings.” Another survey shows
a steep positive trend since 2010.
Yet another survey suggests that
markets like the U.S. are generally
safe havens (at least, certain cities
and regions) but significant uncertainty
exists.

If one is to be in real estate, commercial
real estate (CRE) is surely a
nice place to live right now.
A major survey recently noted that
investors are “excited” about continued
positive trends in commercial
real estate (CRE). Many investors
would note a lack of quality product
characterizes many strong markets
with Boston among those. However,
it notes some concerns about the use
of “aggressive” residual capitalization
rates.

What is the difference between
a capitalization rate and a residual
capitalization rate? Aren’t you glad
you asked?

There are many capitalization rate
flavors out there. Everybody has an
opinion as to what the “cap rate” is,
could be, or might have been.

A cap rate is used to capitalize
income and represents the relationship
between income and value/
sales price. Thus, most commonly,
Net Operating Income (NOI) is capitalized
(i.e., divided) by the “cap”
rate to arrive at a value. Also, a cap
rate can result by dividing NOI into
a sales price or value. NOI is income
remaining left over after operating
expenses and vacancy/collections
are subtracted from gross income.
Getting to NOI can in itself be an
artful struggle: disagreement can
arise between otherwise qualified
professionals as to what should be
included and excluded to get NOI.
Without further discussion about
NOI, cap rates arise based on current
income, trailing historical income,
average income, anticipated income,
pro forma income, and so on. Most
discussions regarding cap rates
begin with defining what income
and assumptions about the income
hold true.

A residual cap rate is a rate used
in discounted cash flow analysis
(DCF), another form of processing
income to produce value. DCF analysis
processes income flows forecasted
over a holding period – say,
10 years – rather than “capitalizing”
one year’s NOI.

Many investors, appraisers, and
lenders find DCF crucial in evaluating
properties with irregular income
patterns or shifting lease characteristics.
Many believe DCF provides
an extremely accurate model of the
anticipated behavior of a piece of real
estate. This may be true, as long as the
assumptions reflect what investors
think will happen. As with anything
that makes assumptions about the
future, rosy feelings about the future
lead to unrealistic assumptions and
an uncooperative economy can put
DCF models on their heads.
One key assumption in DCF is the
terminal rate. This rate capitalizes
the final year’s NOI to create a reversionary
value at the investment’s
end and whose present value (a value
that accounts for the time value of
money) is added to the present value
of the cash flows.

This is a key assumption. As that
future value is usually a big one,
even discounted from a 10 year horizon,
it weighs substantially on the
value as a whole. Someone feeling
extremely positive about the future
would forecast an aggressive (“low”)
terminal rate which would have the
effect of increasing the value. (It’s
actually one of only several ways
to influence the value upwards, but
that’s for another time.)

Most surveys have continued to
show some form of cap rate compression
almost across the board in
property types. This is true for residual
rates as well as going in rates.
Even in markets that can be
classified as recovered and in expansion,
aggressive residual rates
represent “bets” on the future that
may not come to pass. No one can
predict the future with certainty;
thus, prudent forecasting based on
a sound understanding of the current
environment and the thinking of intelligent
investors must prevail over
the “buy now, worry later” investor
mentality.

It’s not time to sound alarms. It
is worth considering the effect of
optimistic “short term” predictions
applied to “long term” investments.
Blue skies don’t last forever. A real
estate investment that is held for
ten years is likely to experience
more than a few “bumps” in the
economic road.

A major survey recently noted that investors are
“excited” about continued positive trends in commercial
real estate (CRE). Many investors would note
a lack of quality product characterizes many strong
markets with Boston among those. However, it notes
some concerns about the use of “aggressive” residual
capitalization rates.