Estimating Terminal Cap Rates

[Fred]

While Buyers do not set the market by themselves, Buyers do set the price of transactions.

I'll overlook that those two sentences contradict each other and assume you mean the second one. I guess I was wrong, you were not making it sound like buyers set the market (price) - inadvertently.

I have to call some of those Presidential candidates who are worried about people who can't afford health care to tell them to stop worrying - patients set the price of transactions.

 

[Howard Klahr]

I'll overlook that those two sentences contradict each other and assume you mean the second one. I guess I was wrong, you were not making it sound like buyers set the market (price) - inadvertently.

Buyers set the prices and Sellers determine availability, both set the market (supply and demand).

Health care is a whole other issue. The thing that amazes me about health care is that the patient with no insurance paying in full cash the day of services rendered is ultimately charged the highest price.

 

[Fred]

Health care is a whole other issue.

Not really. Your theory - buyers determine price - either holds up or it doesn't. Pick any market: gas for your car, prices at the store, Even in command economies, like the USSR, buyers had to bribe sellers who wouldn't supply goods and services and legally fixed prices.

 

[CBBoston]

It's been 20 years since I've taken a cap course but it amazaes me that they still talk about Js, Ks, Ellwood (digression - I went to HS with Ellwood's grand kids. Now you have and in to the 6 degrees of seperation.) and that other arcane stuff except as historical perspective. As was mention in other posts we don't need these algebraic tricks any more with the advent of spreadsheets and programs like Argus. What amazes me even more is that appraisal hasn't embraced mainstream finances approach and terminology to calculating the value of a financial asset. Nowhere in modern finance do you see the use of sinking fund factors to capture the return of equity in discount models. Implicit is that equity is returned in the terminal value at the end of the holding period. If one expects conditions to change that much, you shouldn't being doing direct cap anyway.

I don't find direct cap to be inferior to the DCF, except where cash flows interest rates or required rates of return might be volatile.

This brings me back to the terminal cap rate. If investors, and investors do play a roll in determining maket expectations, believe that interest rates will increase by the end of their holding period, they will adjust going-outcap rates upward. If they expect interest rates to fall, they will adjust going-out cap rates downward. Only in a stable environment will the terminal cap rate be the same as the going-in cap rate.

If as appraisers we don't embrace the terminology and methodologies widely used by investors today, we risk being deemed further out of touch and possible completely irrelevant. Take some basic investment classes at your local college. Even cheaper and more flexible go to university web sites and look over their courses. MIT has most of the class materials and lectures on line. A few even have streaming video of lectures.

 

[hastalavista]

I had to refresh myself with my course material to make sure I got this right (I’ll let you be the judge!).

If there is no change in income (level income) and a change in property value, then
Ro = Yo – (∆a * 1/SFF)
Where ∆a = the anticipated property value change over the holding period and the SFF (Sinking Fund Factor) is based on the Yo for the holding period .
This is, I believe, what Curtis was pointing out to me.

If there is a straight-line (constant dollar amount change) in income and a change in property value (the changes are related but not equal), then
Ro = Yo – (∆a * 1/n)
Where ∆a = the total change in value (percentage) over the holding period and
1/n = equals the annualizer (1 divided by the holding period, n).

If there is a constant compounded rate of change in income and value, then
Ro = Yo – CR
Where CR = the percentage of annual change in income and value.

The course also instructed us how to levelize (or stabilize, take your pick of terms) a changing income stream to a level-stream and apply the shortcuts above as needed for the problem at hand.

Now, after the class, I have solutions in search of problems! :new_smile-l:

It's been 20 years since I've taken a cap course but it amazaes me that they still talk about Js, Ks, Ellwood (digression - I went to HS with Ellwood's grand kids. Now you have and in to the 6 degrees of seperation.) and that other arcane stuff except as historical perspective. As was mention in other posts we don't need these algebraic tricks any more with the advent of spreadsheets and programs like Argus.

CB-

The course briefly touched upon the Hoskold and Inwood premises. Very briefly and it was mentioned in a historical perspective only (we did not solve any problems using these techniques); although the algebra to do so was in the book.

The particular instructor for the class I took had an institutional investor background. He previously managed a University's real estate portfolio (for their endowment and investment purposes), consults now for large endowment funds and is in the process of launching a REIT hedge fund. He made it clear that he approaches the value problems from an institutional investor's point of view. It made for some interesting discussions (most of which I struggled to keep up with:laugh: ) between his perspective and the typical commercial appraiser's experience.

All in all I enjoyed the class.

 

[Fred]

It's been 20 years since I've taken a cap course but it amazaes me that they still talk about Js, Ks, Ellwood (digression - I went to HS with Ellwood's grand kids.

How about they still talk about Pythagoras? Also amazing?

Only in a stable environment will the terminal cap rate be the same as the going-in cap rate.

Who says there is going to be a terminal cap rate at all?

 

[Howard Klahr]

Pick any market: gas for your car, prices at the store, Even in command economies, like the USSR, buyers had to bribe sellers who wouldn't supply goods and services and legally fixed prices.

Basic economic theory, Buyer set prices through demand, even with your extreame example and Sellers set supply. If sellers were to restrict supply, yes prices would go up, but only to the point where buyers are willing to pay. Higher prices result in fewer buyers (and also probably lower profits) and would also encourage alternative products - law of diminishing returns.

Prices and demand for Health care however is influenced by government regulations that alter the mechanics of typical free market (as noted by my example - cash buyers pay higher prices than those covered by insurance dispite the lack of processing costs and collection risk).

 

[Fred]

Basic economic theory,

Whose basic economic theory?

Even starting at the bottom of the economic totem pole, the AI - a market is buyers and sellers meeting at a price. It doesn't say sellers sit around hopeless waiting for a buyer to set a price.

Prices and demand for Health care however is influenced by government regulations that alter the mechanics of typical free market

Prices and demand for real estate however; are influenced by government (VA, FHA, FDIC, etc.) that alter the mechanics of a typical free market.

 

[CBBoston]

How about they still talk about Pythagoras? Also amazing?

The Pythagorian formula is the easiest way to calcualte the length of the hypotenuse. Should the we still teach people to use Visicalc? I don't think so. Let's get rid of calculators too. Dude keep it real.

Who says there is going to be a terminal cap rate at all?

If your do a DCF there will be a terminal cap rate at the end of the holding period. There might not be cash flows after that to cap but that's a different issue.

 

[Fred]

If your do a DCF there will be a terminal cap rate at the end of the holding period.

As I already posted, that is false. There is only a holding period if the appraiser imposes that assumption on the analysis. You can carry your DCF out right to the end of the estimated remaining economic life and beyond.