Cap rate support

[Gobears81]

There are certainly similar threads created on this in the past, so hopefully, I am not bordering on old discussions TOO much, but I am attempting to improve my cap rate support methods and more particularly adapt it to methods that are more reflective of the markets which I work.

My preferred method of supporting cap rates is by examining cap rates of sales and listings and analyzing where the subject falls in that range. Surveys are fine, but they are generally secondary support and has the most applicability when my rates fall near their average. Even then, I wonder if the way that the survey respondents calculate their cap rates is identical to the way that I calculated mine. It seems that the only way to have much confidence in cap rates is by calculating them personally. I actually talked to the owner of Realty Rates (very responsive and good guy, by the way) about the ways that cap rates are calculated, and that is not a dig on their service, just a general weakness for surveys in general. Actually, Realty Rates is quite good for many types of data and a good value.

The band of investment technique has been included in the majority of my appraisals involving direct cap. I find that it is a decent tool in stable markets. But, since there is usually so much more variance in the Re, in volatile markets (particularly those which have higher cap rates), determining where in the huge Re range is appropriate can be a real weakness. Banks seem to like the mortgage rate commentary, but if BOI doesn't have great applicability to some of the markets that I work, perhaps moving said discussion to a market analysis section would be more appropriate.

Using DCR to calculate cap rates is not something that I have used often, and it does not frequently suggest a cap rate that is indicative of the markets that I work.

I would like to hear what methods you are using most frequently, which you have abandoned or recently adopted, etc.

 

[Terrel L. Shields]

I will build up a rate in the absence of other support. And I do use Realty Rate, but again, I rarely do any industrials or other "commercial" outside of agri properties. There, I have some good data since poultry contracts are pretty much uniform within the bird type (broilers, pullets, breeder hens) and thus, calculating a direct cap rate is "easy".

The trick is though, where does my subject fall within that range of cap rates? For poultry farms, age matters. And although an old barn may make as much money per SF as a new one, but the sale price is lower (remaining life is shorter) so the cap rate gets higher as the barn ages. A plot generally gives you the simple pattern that down around a brand new barn, the cap rate will run 9-10% and a barn in need of updates and 20 years old, may exceed 20% cap rate. A plot of age and cap rate gives an excellent indicator of the cap rate on a poultry farm. (Need I say that I compare only broiler farms with broiler farms, egg farms with egg farms, etc.)

 

[nstanbru]

Gobears, the first sentence in your 2nd paragraph is also my preferred method. On occasion, I have used surveys but it's very rare.

 

[NachoPerito]

Analyzing sales to get cap rates is my method 95% of the time. There is a better understanding of what goes into it and why it may be higher or lower.

In the depths of recession I was using a band of investment because there were no sales.

I use the PWC Korpacz survey as support only and have never relied on it, but I have used it to show support for trends over time.

I don't know if I have ever used DCR.

The only other method I have used is talking to brokers and asking what cap rate their buyers would be willing to pay for a type of investment. This was good when I didn't have sales.

 

[Gobears81]

Terrel-when you say build up a cap rate, are you referring to band of investment using Re and Rm?

Nacho-I used DCR once- on my demo report because they were looking for multiple sources of cap rate support but even then, it didn't work out that well. I suppose in some markets with a narrow range of low cap rates, it might work well enough. But it doesn't seem that lenders often increase or decrease terms at a commensurate level of risk increase or decrease-they just won't loan on a project if they don't like it (though that is as an appraiser talking to participants and not as someone that has ever worked in a banking industry, so perhaps that observation could be disagreed with).

One thing that I've struggled with in talking to brokers is that they often calculate cap rates different. Some include minor expenses and reserves for triple net leases, and others take the rents and divide it by the listing or selling price to determine a cap rate. But as long as you understand their basis, then it is certainly a good source.

 

[Terrel L. Shields]

I would use the Build up method, but occasionally do the band of investment. The problem for me is that we have few investors owned properties and often these are pretty mixed bag of financing. It works for some warehouses where you can get rental data and it typically is a NNN lease. But rural commercial property I am likely to look at Realty Rate (especially for something like a Mobile Home Park) and do a second method.

By build up I would enter a "safe rate" plus a "risk rate" (in the absence of data to extract, typically would be 3x the safe rate) and add a recapture rate over the estimated life of the project. This is currently somewhat distorted since the FED has kept T bills so low. This would be akin to Ellwood or a Hoskold Premise

I might also see if I can estimate an Internal Rate of Return as some sort of guide. But mostly I rely upon Direct capitalization.

 

[leasedfee]

GoBears,

My experience mirrors yours. BOI and DCR is instructive in so much as to what is happening within the cap rate due to market forces. (For example, it appears that equity rates have compressed over the years. At the peak in 2008 cash-on-cash actually went lower than the mortgage constant -- yet another warning light that the market had become over-enthusiastic and unrealistic about risk-return.) Using local lender rates doesn't seem to work as well as national lender rates for BOI and DCR so you might want to see if that explains your BOI/DCR problems. Cap rates and BOI/DCR are only sensitive to major market shifts over the years and not very sensitive to day-to-day month-to-month changes. The proposed 25 BP change to the Fed discount rate that freaked out the stock market this week has little to no discernible impact on 30 year mortgages constant and zippo impact on the equity rate (which is expressed as a perpetuity), and thus no impact on real estate caps.

I rarely use DCR, but often use BOI mostly out of habit. During the crisis years, I used a Ellwood spreadsheet template and it reflected that in my market that investors saw this as a temporary downturn. A BOI wouldn't work because it reflects perpetuity of the inputs. I've noticed in proof reading my colleagues, they'd sometimes use the report template's default BOI terms. They'd use apartment underwriting terms for, say, a hotel or retail subject, and then come up with nonsensical results. I'd request that they go do a little research and lo and behold they'd come back with results that mirrored their extracted cap rates and surveys. I'd like to see someone do a survey in a new and different way than what has is done by Korpacz PwC, RealtyRates, or Rerc.

Surveys are useful when you haven't done a property type in a long time and have that shock of "wow, can't believe what's happened to this market" or when you have to develop subtler numbers like land or building yield and cap rates. Once to develop a market conditions adjustment for a large piece of office land, I used the survey technique. I took the survey's market rents, market vacancy and surveyed vacancies and created a nifty index. I was quite pleased with the result, whereas solely relying on just market rents as an index didn't reflect observed marketed trends.

I've written ad nauseum about extracted cap rates being the Gold Standard and apologize if I have overextended my welcome on that topic:
http://appraisersforum.com/forums/threads/office-building-dcf-vs-direct-cap.191168/#post-2310994
http://appraisersforum.com/forums/threads/dcf-article.205567/page-3
http://appraisersforum.com/forums/threads/realty-rates.202870/#post-2516314

 

[Gobears81]

Terrel-I'm not familiar with the built-up technique so I'll read up on it some more. We certainly work different markets, but much of our work is centered on what the metro-ites affectionately refer to as "tertiary", so it could potentially make some sense for me.

Also, I have an abundance of cap rates from MHPs if you can stomach quoting Illinois park caps. There aren't a ton of players in the mobile home park world and I've had a lot of luck calling either them or the brokers for information.

Leased fee- Thanks for the post. This is exactly what I was looking for. I will try looking into the national vs local mortgage rate terms, although I still don't anticipate the DCR being extremely successful once a cap rate reaches a certain point. The BOI is tricky because you are right, it is a perpetuity cap, and once Re gets below or above a certain rate, it says more about growth rate expectations than anything else. I used a 20% cap rate recently and BOI was included in that appraisal. The Re used stuck in my mind and I probably should have just omitted that method entirely. Actually, that appraisal is part of the reason that I posted this topic, since I supported my cap rate well by sales/ listings, but also shouldn't have shown BOI.

 

[leasedfee]

To apply the BOI reliably, you have to get the equity rate by extracting it from sales, which sorta renders moot performing the BOI. Surveying for the equity rate is even more fraught with problems than surveying for an overall rate. What situation was a 20% cap rate, maybe an interim use or leasehold interest burning off?

 

[hastalavista]

I've written ad nauseum about extracted cap rates being the Gold Standard and apologize if I have overextended my welcome on that topic...

(my bold)

Not and never ad nauseum, Tim.
I wish you would post more.
Indeed, I passed up an assignment on a leased fee interest of an airplane hanger/storage complex because it was beyond my comfort level; I wish I would have read your TAJ articles first (I still may have declined, but probably not as quickly! ).