Build Up Method for Cap Rate

[Terrel L. Shields]

Anyone seeing how problematic low interest rates are in the build up method?

With T bills 10 yr hovering about 1.7%, you have to have a "risk rate" of triple or more (far higher percentage wise) or you end up with an extremely low cap rate...far lower than the direct caps calculated suggest.

What is your thought processes about that issue? The method is hokey but what's your spin?

T bill 1.7%
Risk Rate 3.4% 200% ?
Liquidity 1.0% (I really think as difficult as a loan is to get, perhaps bump up?)
= Discount rate
+ recapture
=
OAR

 

[shaxton24]

I think comparative returns on other investments can only be compared to the Yield IRR or MIRR for commercial r.e. The cap rate is not a return.

A modified-type cap rate could be a true return if it is based on stabilized net income and the net income is net of all below-NOI expenses.

But a build-up type method is ok, so long as you feel you can't get better comparable data with an already built-up rate of return of a competing investment type.

 

[PropertyEconomics]

Terrel I agree ... not only are mortgage rates low (ie return to the mortgage) but equity return also appears to be lower as a result because there are no other real places to put that money that will provide an adequate return comparative to risk.

I am starting to think that OAR's in many segments of the market are lower than they should be starting the trend of what I will term optimistic pricing / valuation once again.

 

[Rlong]

I review more than I "build up" myself currently; I am not sure that methodology holds up well in the current environment. The better appraisals I read try to provide 2-3 indicators (comps from grid; other local comps; range from local report data; published rate reports; and built up). I think the built up indicator is currently one of the less reliable ones. Your point is often borne out; for the income approach to make any sort of sense (in relation to other indicators) a "built up" rate tends to be well "built up" (i.e. pumped up as it would be crazy low without "building" it higher.

I would be interested in other peoples takes as well.

Bob

 

[Terrel L. Shields]

I normally have enough data to "do" direct cap rates, which I have more confidence in. However, the spread between those rates and a build up rate seems to be increasing.

If I apply a similar build up in a hoskold's premise (like Inwood sinking fund) (something you might do for a gravel quarry) you come out with an absurdly low number and the "years to payout are so large...well, I certainly wouldn't want to invest at that valuation.

I do agree that income expectations of investors has dropped dramatically and I don't think it is justified when I start to measure "risk". Thus, a premise that tries to vet the risk rate as a multiple of the T bill rate best use a very high multiple.

In poultry farms, I saw a huge number of farms sell 2002-2006 for 9% and 10% cap rates on a rapidly depreciating enterprise (poultry barns have short lives, often less than 20 years). Today, 15 - 18% is the norm. Clearly, applying that metric suggests the risk rate portion would be 5-10 x (and maybe more) on the 10 yr T bill .

 

[Michael S]

I just took the Advanced Income course and both the book and the teacher specifically said not to use the build up method for deriving a cap rate because of the difficulty in determining all of the risks (liquidity, environmental, etc.).

Sales have finally started occurring a bit more frequently which usually provides enough market support for cap rates. If there's no sales data it's usually a sign that investors aren't buying that type of property and that an owner-user might be the most probable buyer. That's certainly been true of most of the industrial properties I've looked at recently. On one recent report in order to get the income approach up to the sales comparison approach I would have had to use a cap rate below 8%. No investor is going to accept that kind of cap rate on a local tenant with at best a 5-year lease on a 30 year old building, not when there are 10-20 year leases to credit tenants with brand new buildings available at similar cap rates.

 

[The Warrior Monk]

T bill 1.7%
Risk Rate 3.4% 200% ?
Liquidity 1.0% (I really think as difficult as a loan is to get, perhaps bump up?)
= Discount rate
+ recapture
=
OAR

I'll use built-up rates in conjunction with other market data. There is very, very little market data to derive a direct cap rate from where I work for various reasons.

However, we (and most other commercial appraiser I know) don't use the T-bill rate. It's more common to use one of the corporate bond rate, which includes some level of risk, then account for liquidity issues. This gets reconciled with the limited amount of real property data available.

In my practice, I've seen some appraisers really screw this one up by using only built-up rates. One has to know the market and be very careful when doing so.

 

[Highlight17]

Built Up Method

I think comparative returns on other investments can only be compared to the Yield IRR or MIRR for commercial r.e. The cap rate is not a return.

A modified-type cap rate could be a true return if it is based on stabilized net income and the net income is net of all below-NOI expenses.

But a build-up type method is ok, so long as you feel you can't get better comparable data with an already built-up rate of return of a competing investment type.

"The cap rate is not a return"

Actually, the cap is rate is measure of return (technically its a ratio) as it consists of 'return on', and 'return of' components. A property's occupancy level and economics are irrelvant in so much as this is concerned (despite challenges in deriving a supportable cap rate, what it represents does not change due to occupancy characteristics).

 

[Terrel L. Shields]

I certainly wouldn't want to bet the ranch on a build up method but I do understand teh difficulty in certain properties of applying direct caps in the absence of sales. I don't do industrials so I usually don't concern myself with that.

I just pondered the implication that low T bills would somehow mean lower overall rates. Certainly no one would want to take a risk that was less than a T bill rate...but when T bills are driven down to very low levels, it appears they are pretty contrived numbers that have little relationship to the risk...and in my opinion, the lower the T bill rate the HIGHER the risk rate should be because the T bill is saying really bad things about the overall economy. I like the idea of an IRR plus as a basis for analyzing sales.

 

[Restrain]

IMO, the "risk factor" should consider the tax/political uncertainty that has entered the market over the last few years. The rapid changes and negative tax factors have created such market fears that, outside of a few states, the uncertainty factor becomes the over-riding factor. Perhaps a survey of investors to see what the impact is would be appropriate, especially with the wide range between rates.