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Capitalization Rates: Predicting the Future
By Brian Bader, CPA
Capitalization rates for real estate have continued to remain at relatively low levels despite the significant rise in short term interest rates over the past two years. Theories abound as to the reason. Those predicting that cap rates must rise (prices fall) rely on the traditional argument that cap rates (the going-in ratio of in-place income to price) always track interest rates. The reason is that real estate buyers almost always utilize mortgage financing to achieve upside leverage. As a result, higher mortgage rates depress purchase prices.
Example
Assume an investor can obtain a 75 percent mortgage loan at 6.0 percent interest in order to purchase a property. The investor's required return is 10 percent. Exhibit 1 shows that he can afford to buy the property at a 7.00 cap rate. Assume the property has net operating income (NOI) of $100,000. The investor can pay $1.428 million for the property ($100,000 divided by 7.00%).
Effect of Rising Interest Rate
Assume that after a period of time, the investor wishes to sell the property. At that time, a buyer can obtain a 75 percent mortgage at an interest rate of 7.0 percent. As Exhibit 2 shows, in order for the new buyer to obtain a 10 percent return, he must buy at a cap rate of 7.75 or 75 basis points over that of the original investor. This yield can be obtained only at a purchase price of $1.290 million or $138,000 less than the original investor paid. In short, a 1 percent rise in the interest rate causes the value of the property to drop by almost 10 percent (assuming the required return is unchanged.)
Effect of Rising NOI
A rising NOI can offset all or much of the loss due to a rising cap rate but this may require a long holding period. Assume the NOI in the above example rises at 3 percent a year, most or all of which is due to inflation. At the end of five years, NOI will have risen to approximately $116,000. Assuming the cap rate remains unchanged at 7.75, a sale at that time will be at a price of $1.497 million, or a profit only of $69,000 (5 percent) to the seller.
Real World Considerations
In the real world, cap rate calculations are not as precise as described above. First of all, NOI can be calculated in a number of different ways. To name only two variations, NOI for an office building may or may not include projected tenant improvement (TI) costs and replacement reserves. Second, cap rates often are stated in terms of all-cash transactions rather than leveraged ones (as in the above examples; this ordinarily means lower cap rates since the benefit of leverage is ignored). Nevertheless, the general statement can be made that if both NOI and the cap rate are unchanged during the holding period, the investment is like a bond bought at par and held to maturity, hardly the expectation of most real estate investors.
Will Interest Rates Rise?
On the more significant question as to whether interest rates indeed will go up, the jury is out. While it has generally been assumed that this is bound to happen, some commentators are now saying that rising inflation is not a realistic threat and that the continuing flow of foreign funds into the U.S. markets will prevent interest rates from increasing to any a significant extent. Only time will tell.
| Exhibit 1 |
| Component |
Percent |
|
Required Return |
Weighted Return |
Debt |
75% |
X |
6.0% |
4.50 |
| Equity |
25% |
X |
10% |
2.50 |
|
100% |
|
|
Cap Rate 7.00 |
| Exhibit 2 |
| Component |
Percent |
|
Required Return |
Weighted Return |
Debt |
75% |
X |
7.0% |
5.25 |
| Equity |
25% |
X |
10% |
2.50 |
|
100% |
|
|
Cap Rate 7.75 |
Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman’s New York office. He can be reached at (212) 885-8203.
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