Cap Rate Comps and True Value

[Chris Yeakel]

Hi all,

When purchasing a commercial multifamily, should one use cap rate to determine the “value of the purchase”, the potential value of the property, or both?

For example; if I have a property selling at a low 6% cap rate, should I have the mindset of “This is buying at a premium, I need to buy at a higher cap” or the mindset of “this is at a 6% cap and I think I can get it to 10%”?

Ultimately purchase value vs future value

Thanks for any clarity!

-Chris Yeakel

[Brian Burke]

Great question, Barry.  This question trips up a lot of new investors because they think that a 50% occupied destabilized property in a 6% cap market is worth the number resulting by dividing the in-place income by 6%.  But that's not how it works.

The market cap rate is for performing assets. Non-performing assets can and will have a much lower cap rate than performing assets, and can even have a negative cap rate. Which is why cap rate has nothing to do with the price you should pay when acquiring a property. Instead, you should be looking at IRR, CoC and equity multiple. But if you are determined to use cap rate as some sort of yardstick, read on for a way to twist the concept so it produces a meaningful result...

You can't say that "I'm buying at X% and the projected NOI cap is Y%" because it will cost you more money than just the purchase price to bring a non-performing property to stabilization. You'll likely have to fix up units, turn them to make them ready, and/or perform other deferred maintenance corrections.

Instead, look at Stabilized Yield On Cost and Development Spread.  Here's how:  

First, project your income in future years by taking the rent you expect to achieve each year, and subtract economic vacancy for each year.  This Economic Vacancy will decline as you bring occupancy up and rents up and collections up, etc.  In two years, perhaps three, perhaps four, the economic vacancy will level off and normalize.  This is called Stabilization.

Next, project operating expenses for each year, and then subtract that from the number above, to arrive at each year's Net Operating Income (NOI).

Now add up all of the money you've spent, from the time of purchase all the way up to the year of Stabilization. Purchase price, closing costs, and all capital improvements (disregard operating expenses unless you came out-of-pocket to fund them).  That's your Total Cost.

Next, divide the projected NOI in the year of stabilization by the Total Cost. The result is your Stabilized Yield On Cost. It's kinda like cap rate, but it's not. Cap rate includes only the purchase price. SYoC includes everything.

Next, compare the SYoC to market cap rates.  The difference is the Development Spread.  Stay with me, I'll give you an example in the next paragraph.

Here's what it all means:  Let's say that you bought a non-performing property at a 1% cap rate to in-place income.  That's all there is to say about that, because it doesn't matter.  Now, if you project that the project will stabilize at a 8% SYoC, and you project that the market cap rate for this type of property in this area will be 6% at that time, you have a 2% Development Spread (8% minus 6% = 2%).  What this means is that you "created" 33% of increased value (2% Development Spread divided by 6% market cap rate = 33%).  

So let's say you spent a total of $1 million to purchase, rehab and stabilize a non-performing property and it took you three years.  The purchase price was a 1% cap rate.  All your friends said you were paying too much and were crazy and the property was only worth 1/6 of what you were paying.  

But now your property is worth $1,333,333.  You borrowed 50% of the $1 million so you really only put out $500,000 and you "made" (on paper) $333,333 with it, which over 3 years is 22% annualized return on your money if you don't even factor in any profits from operations.  Now you point this out to all of your friends that said you were crazy, and who's laughing now?