Estimating Terminal Cap Rates

[Ken B]

Denis: As a residential guy who did the commercial classes first and who is now doing commercial work, I see advantages and disadvantages to the way we took the courses. With no commercial field experience beforehand, we had no bad habits or presumed knowledge. With some field experience, we would have been able to put some of the information into better context. I have been thinking it would be interesting to take the 510 course again as a CE course after I get the CG license just to see how much more I actually take away from it the second time around.

 

[Lost Cause]

Terminal vs. Going-In Cap Rates

I've never seen a convincing argument as to why I would use a terminal cap rate any different from one applicable today.

 

[hastalavista]

I've never seen a convincing argument as to why I would use a terminal cap rate any different from one applicable today.

JH-

Does that mean your typical Rn = Ro, or does it mean that your are just not convinced they should be different? :new_smile-l:

I can see in some cases why they could be similar (no expected changes, relatively short holding period, anticipated regular maintenance that reduces physical depreciation), but I can also see many cases where the argument for a different (and higher) rate is persuasive- mainly uncertainty and physical depreciation.

Thanks!

 

[Howard Klahr]

I've never seen a convincing argument as to why I would use a terminal cap rate any different from one applicable today.

Based on a 10-year DCF, the property is 10 years older (i.e. reduced remaining economic life) as well as accounting for some of the risk associated with forcasting. Most importantly, as appraisers we are supposed to reflect the actions of the market participants. This is how the institutional plyers perform the analysis.

Ken - I periodically go through course materials and texts from previous courses and often glean something based upon having more experience than when I originally went through the course. It almost takes on a new perspective.

 

[Lost Cause]

Denis, I am not convinced they should be different.

Based on a 10-year DCF, the property is 10 years older (i.e. reduced remaining economic life) as well as accounting for some of the risk associated with forcasting.

That is the usual argument, but I'm not buying it. On the first point, I would say that ten years is not very long for a well-maintained commercial structure. Depreciation is often quite minimal over such a period. On the second, I never have been able to understand increasing the rate for the "risk associated with forecasting". It is just as possible market cap rates will decline as increase over the forecast holding period.

There was an excellent article discussing this issue some years ago in (I believe) The Appraisal Journal. I will cite it if I can dig it up.

 

[Fred]

Look at the last 15 years. Take most property types, and the cap rates from 11-15 years ago were lower 10 years later.

 

[Curtis West]

Most importantly, as appraisers we are supposed to reflect the actions of the market participants. This is how the institutional plyers perform the analysis.

Agree with the above, but most properties are not investment grade properties that institutional players are concerned with.

If the rate of decrease in NOI is greater than the rate of decrease in value the terminal rate will be lower. Otherwise there will be a different relationship.

 

[Caligirl]

I would say that ten years is not very long for a well-maintained commercial structure. Depreciation is often quite minimal over such a period.

While in theory I agree, the market reality is that each property type 'ages' at different rates. For example, consider the difference in 'wear and tear' and required regular maintenance over 10 years for a retail project vs. a large apartment complex.

 

[Howard Klahr]

"as appraisers we are supposed to reflect the actions of the market participants. This is how the institutional players perform their analysis."

Also, the majority of commercial loans are for a 10 year term, many institutional investors base their portfolios around a 10 year hold and 10 years roughly reflects 20% - 25% of the economic life for most commercial properties.

While you are free to perform your analysis however you choose, based upon my experience with institutional investors, you value conclusions will be approximtely 5% - 7% higher than those of most institutional participants. Concequently, would this then truely reflect "market value"?

most properties are not investment grade properties that institutional players are concerned with

While "most" properties might not reflect investment grade, you're categorization represents the number of properties not the value of the properties. The overall value of investment grade properties is higher than that of non-investment grade when focused on the major catgories of commerical property.

the rate of decrease in NOI

Why is there a rate of decrease in NOI?

 

[Curtis West]

If the rate of decrease in NOI is greater than the rate of decrease in value the terminal rate will be lower. Otherwise there will be a different relationship.

Correction: the terminal rate will be higher.