The Capitalization Approach to Income Property Valuation as Interest Rates Rise

Dan Harkey, at DanHarkey.com writes great articles about real estate on his website. You can read more articles by visiting his website. In this article, he discusses “The Capitalization Approach to Income Property Valuation as Interest Rates Rise.”

Definition of capitalization of earnings:
The capitalization approach estimates the fair value of an asset such as income-producing real estate by calculating the net present value (NPV) of expected future net profits or net cash flow, referred to as Net Operating Income. The capitalization of earnings is determined by taking the property’s projected annual net income and dividing it by the market capitalization rate (Cap Rate).

Understanding the income capitalization approach (Cap Rates) in the property valuation is critical when investing in any income-producing real estate or underwriting for a new loan. The concept is essential to commercial realtors, lenders, developers, and investors in income-producing real property.

Net income divided by the capitalization rate will reflect the expected value of the income-producing asset.  Re-stated: Net operating Income divided by the capitalization rate= value (NOI/Cap Rate=Value).

Example: Property Income and Expense Statement Format

The calculation to arrive at the Net Operating Income

*Market rents should be used for rents attributed to vacant space, lease renewals, and owner-occupied space:
** Depreciation, capital expenses, and loan cost are not considered in the calculation of the NOI

Stated one more time: Capitalization Rate represents the annual Net Operating Income (NOI) divided by the cap rate to derive the property asset value (NOI/Cap Rate= Value).

Why do we use Capitalization Rates?

The capitalization approach is a “comparative method” of valuing a property with similar properties, similar income streams, in similar geographic locations, and risks that will yield comparable rates of return. The comparative method will reflect the estimated value conclusion. The result will allow a lender to determine if the loan-to-value is acceptable by underwriting guidelines.

Cap Rates are only one metric. Since the capitalization approach assumes that the property is debt-free, the value will be the same whether the property has leveraged debt or is debt-free. It represents a present market snapshot of the investment value and does not consider loan debt service or financing costs.

If an investor finances his acquisition, as most people do, alternative yield formulas,  such as cash-on-cash return, will be helpful. Sophisticated loan underwriters and investors may also calculate an internal rate of return. These calculations assist in establishing that the property is income-producing and a worthwhile investment.

A licensed commercial appraiser may conduct a rent survey to determine market rents for a type of property in a geographic area. Market rents are the amount of rent expected for the use of a property compared to similar properties in the same market area. Market rents may or may not be the same as actual rents (contract rents). There are many instances where the existing rents are above or below-market rents.  A tenant with a long-term lease may have locked in lower rents sometimes in the past.

A property owner may own property under a title method, such as The Archie Bunker Family Entertainment Corporation, and occupy all or a portion of the building in a different title method, such as Archie Bunker Limited Liability Company. He may charge above or below-market rents to himself for tax purposes.  Actual rents may also be higher than the market.   In this case, the appraiser would use market rents rather than actual rents to determine the Cap Rate. There will most likely be a lease agreement between the property owner and the tenant, even though they are related parties.

There are other instances where a conventional market Cap Rate analysis is inappropriate. The alternative method is a discounted cash flow analysis such as original ground-up construction. The building cost and cash flow, including a lease-up period, will be projected over a reasonable time to the point of stabilized occupancy. A competent appraiser can construct a model estimating a future projected cash flow and using net present value discount formulas to estimate the capitalization rate. The result may differ from the market comparison method.

Suppose you have more than one income property with similar characteristics in a geographically close location sold in arm’s length cash transactions, and the income stream data is available. In this case, web-based databases track comparison capitalization rates (Cap Rates.)

There is an essential difference between market rents and current actual(contract) rents in the Cap Rate valuation process.  Compare two different buildings, both identical, but the first property is well-kept and rented at a market rate and a second building with deferred maintenance. The property with deferred maintenance has below-market rents of under 30%. In both cases, a lender and the appraiser will use market rents to determine the (NOI).  The second building assumes that a new owner will upgrade the building and adjust the rents upward to a market rate. The value of the second building would be adjusted downward or discounted to offset the cost to cure (cost to upgrade the building).

I once underwrote a prospective loan file for an industrial building in Richmond, California. The property was leased to a third party for 99 years, with 30 years remaining. The lease rate is only 18 cents per square foot triple net for the remaining 30 years of the lease. The property owner and loan broker argued belligerently that the value is based on today’s rents. A lender, and appraiser, will only use the lower rents because of the long-term lease.

The same is true for a rent-controlled property. If increasing the future rents is prohibited by government intervention, the appraiser will use rents allowed by the rent control board. The distinction is market rents vs. constricted rent control board rents.

Databases with historic rents are available to determine market rents and calculate a correct capitalized valuation.

Historic market Cap rates may vary, even in the exact geographic location, depending upon the building improvements, effective age, class of construction, off-street parking, furnished or unfurnished, condition, compliance with zoning, easements, or lack of needed easements, and amenities.  Examples include Class-A vs. Class-C office, industrial, apartments, older dated, economically obsolete and under parked compared to a new modern building with adequate parking and currently popular amenities.

Advantages and disadvantages of the capitalization approach to value:

Advantages:

1. The method converts an income stream into an estimate of the value of the income-producing real estate.
2. The method is a common standard in the appraisal, lending, and development business.
3. While the income capitalization approach is common in evaluating commercial income-generating properties, the method can theoretically be applied to any income stream, including businesses.
4. Commercial appraisers are a reliable source for determining market cap rates.
5. Commercial realtors provide  an excellent source of cap rates with websites such as Costar and Crexi
6. Online databases such as the CBRE/US-Cap-Rate-Survey-Special-Report-2020 obtain reliable data.

https://www.cbre.us/research-and-reports/US-Cap-Rate-Survey-Special-Report-2020

Disadvantages:

1. The method reflects “comparison only with similar properties in a close geographic area.”  The procedure does not consider liens on the property and debt service. A cap rate calculation assumes as though the property is debt-free. The capitalization approach does not calculate the overall net cash flow or cash-on-cash yield when a property has leveraged debt.
2. The results of a cap rate calculation are specific only to a similar area with similar properties within certain market segments. You could not use Newport Beach, California cap rates to compare with a similar building with similar usage in Riverside, California. Also, the demand for properties and cap rates for different segments of the real estate market change over time. Currently, residential income properties and industrial properties will continue to be in demand. I read one estimate that industrial in the U.S. will require an extra billion square feet of warehouse by 2025. Patterns change! Office and lodging/resort-related properties, not so will.
3. The method contemplates stable economic market conditions. If a market experiences a significant downturn, collapses, or is subject to extreme political uncertainty, market cap rate calculations may be rendered irrelevant. Currently, loan interest rates are rising, indirectly affecting capitalized values.
4. Relying on a cap rate in an unstable market condition is difficult. Market rents may be fluid; with higher rates of foreclosures, tenants defaulting much more frequently, vacancy rates go up, and replacement tenants will ask for more increased rent concessions, thereby bringing the market rents down. Additionally, owner operating expenses may become constrained.
5. Forecasting future income streams involves a high degree of professional judgment and is therefore subject to variation.
6. Professional judgment is subject to subjective vs. objective interpretations about expectations of future benefits.
7. The method may result in miscalculations when estimating the cost of capital outlay for upgrades to bring the property up to current standards. All job subsets have a price, time, and frustration allocation, including municipal approvals, building reconstruction, modern materials, safety, zoning, environmental, and social equity requirements.
8. Property amenities, parking, easements, recorded encumbrances, and compliance with building and zoning regulations require complex analysis to determine the effect of value.
9. A lease-up period is only an estimate and may not be correct.
10. Alleged appraiser and lender biases for racially segregated neighborhoods are known to exist.

Is there an ideal Cap Rate?

Investors should determine their risk tolerance to reflect their portfolio’s ideal risk-reward level. A lower Cap Rate means a higher property value.  A lower Cap Rate would imply that the underlying property is more valuable, but it may take longer to recapture the investment. If investing for the long-term, one might select properties with lower Cap Rates. If investing for cash flow, look for a property with a higher Cap Rate. Declining Cap Rates may mean that the market for your property type is heating up, and demand is intensifying. For Cap Rates to remain constant on any investment, the asset appreciation rate and the NOI increase it produces will coincide.

Below are examples of changes in NOI and Cap Rates that cause asset values to rise or to go down:
As NOI increases and Cap Rates remain the same, asset values will increase.
($300,000 reflects net operating income and .06 reflects a 6% cap rate)

• $300,000 /.06 = $5,000,000
• $350,000 /.06 = $5,833,000
• $400,000 /.06 = $6,666,666
• $450,000 /.06 = $7,500,000

As NOI remains the same and cap rates rise asset value will go down:
($500,000 reflects net operating income and .03 reflects a 3% cap rate)

• $500,000 /.03 = $16,666,666
• $500,000 /.04 = $12,500,000
• $500,000 /.05 = $10,000,000
• $500,000 /.06 =    $8,333,333

Correlation Between Cap Rates and U.S. Treasuries:  

The U.S. Ten-Year Treasury Note (UST) is considered a risk-free investment. USTs yields have been on a broad decline for many years but are currently rising. As interest rates increase, investors who bought USTs at a lower rate will find that their bonds will go down in value. Bonds purchased at the new higher rates will be in high demand.

As interest rates rise, cap rates will go up, and asset values will go down over time. With so many uncertainties in the market and growth projections constantly being revised, the spread between UST and Cap Rates has not remained constant.

When the government intrudes on the market, the results are artificial. Government intervention always caused capitalization rates to go down, reflecting higher values. Near-zero interest rates have also caused a dramatic inflationary spike in goods and services.

Summary:

The most significant reason for investing in real estate is property appreciation from excess demand. Property appreciation from inflation is not part of the cap rate calculation. For investors, lower interest rates and tax benefits of owning commercial real estate may be the driving force to make such an investment. If the property has leveraged financing, there may be write-offs for loan fees, interest expenses, operating expenses, depreciation, and capital expenses.

Interest rates have been forced down to artificially low rates, below inflation, by government mandate! Refinancing at lower rates has resulted in lower debt service payments. Cash flows of income-producing properties have increased, reflecting a higher net operating income. Rates are now rising and will continue their upward trend in the foreseeable future.

The government intentionally creates market distortions that benefit the insiders at the top of the economic spectrum. The results are always artificial. Favorable reactions to distortions cause capitalization rates to decrease, reflecting higher values. Near-zero interest rates have also caused a dramatic inflationary spike in goods and services. All asset classes have now been “spiked with 200-proof illusions” that make everything seem fantastic on the surface.

But hangovers, the day after the party ends, are no fun.

I believe an immediate 2% interest increase would collapse the economy overnight. A one-to-two hundred basis points increase in lending rates (1% to 2%) would shatter the punch bowl into fragments. But, the rise in interest will occur over a year. Main Street and small capitalist entrepreneurs will bear the brunt of widespread financial damage.

Interest rates are increasing because the government realizes that inflation will only accelerate if it does not stop or slow. Increased interest rates will result in newly originated loans having higher payment structures. Higher loan payments indirectly and over time cause cap rates to rise and values to go down.

Values may not go down immediately, but the demand to purchase income-producing properties will subside because ownership will make less economic sense. To add flames to this fire, the government, including federal and state, is passing legislation that will destroy investor motivation to own.

The seven-pronged negative whammy is now in process.

1)  Interest rates are rising and will continue growing in the foreseeable future.          
2)  Increase in interest rates will reflect larger loan payments.
3)  A property’s net cash flow will drop due to increased debt service.
4)  General loss of investor confidence is occurring in the overall economy.
5)  Loss of investor interest in purchasing an income property.
6) Overburdening & abusive government intervention always negatively affect property ownership. The government will always attempt to extract unearned financial benefits from private property owners to fix the problem.
 7) All of the above will cause capitalization rates to rise and property values to go down.

Remember that the capitalization approach does not consider increased debt service based upon higher interest rates. Higher interest rates will lower all real estate prices on a macro level. But, as interest rates go up, borrowers will feel the sting of higher debt service payments. Some property transactions may become less appealing financially. As purchasers and borrowers elect not to purchase, that may compound and create more unsold inventory. Some sellers may get desperate and reduce the price to sell quickly. The lowered price would result in a higher cap rate.
How dramatic will lower real estate prices be over time? Between 2007 and 2010, we witnessed the downward value contagion spread resulting in substantially lower values and increased capitalization rates.

The hangover is upon us. The seven-pronged whammy is not a new phenomenon but it is here. It was delayed while  participants enjoyed the Federal Reserve’s punchbowl with “free-for-all 200-proof infused close to zero-interest rates.”

Dan Harkey
DanHarkey.com