Wrapping it up: Cap Rates, Comps and Offer Prices
Well, we’ve reached week 10 and the end of our CYA Series. We’ve discussed why you need to review the numbers presented to you, various items to watch out for on the revenue side and the big-ticket items on the expense side. At this point, I hope you’re taking a P&L presented by an agent and adjusting the NOI to something that’s more realistic and better reflects the actual performance of the investment property. Now that you have this adjusted number, however, you need to turn it into a valuation for your offer price.
There are a few ways you can determine your value. The most common calculation you’ll see in an Offering Memorandum is the capitalization rate (“cap rate”). I personally feel there are better metrics because this cap rate doesn’t factor in future performance, cost of capital, additional funds needed, etc.
The cap rate simply reflects the initial yield on purchase price that an investor in that market will target.
You can determine an acceptable cap rate by looking at recent sales or you can determine it based on your own personal yield expectations. If you’ve computed your adjusted NOI, however, the simplest way to get a quick offer price is to use the cap rate proposed in the presentation with your revised numbers. Assuming it’s not offensively low, using their cap rate eliminates one variable from the discussion. They can debate how you got to your NOI, but they cannot question this cap as it was their own.
A more practical use of a cap rate is on the exit. The exit cap rate works the same way; the yield your future buyer would be looking for when they take the property off your hands. If you’re underwriting to an IRR or an equity multiple for investors, the disposition price will be one of, if not the biggest, variables in determining these numbers.
Today, some people will push you to use a substantially higher exit cap, one that’s closer to a historical norm due to today’s cap rate compression. I would advise against such an overly conservative approach. Yes, it’s always better to lean toward the safer side, but you also want to be realistic and actually get a deal every now and then. Cap rates look low on an absolute basis but, historically, they are right were they should be, if not a bit higher than would be expected.
If you’re in a 24-hour city or a major coastal MSA, you may be seeing some rates in the 4% to 5.5% range but a majority of the country is still seeing sales in the 5.5%-7.5% range. What these actually represent is a risk premium over the risk-free rate (10yr Treasuries). It’s the added yield an investor will need to justify owning this real estate rather than the safety of the government bonds. Historically, this premium has been around 250-300 basis points over the 10yr. As of this writing, the 10yr is 2.40%. That would imply cap rates around 4.9% and 5.4%.
As we’re seeing rates substantially higher in most markets, it would seem that interest rates could rise a fair bit before we’d even see cap rates move up. As such, jacking up your exit cap will be overly conservative. I would recommend a simple 10-20 basis points per year of hold. If you’re anticipating a five-year holding period, that would mean increasing your going-in cap rate by 0.50% to 1.00% for the exit.
Armed with your adjusted NOI, a going-in cap rate and an exit cap rate, you can now run any numbers necessary to calculate your investment target metrics and determine your offer price. Before you go running to the selling agent with this number, you’ll want to look at the second way to value an investment property to make sure your offer is reasonable and give yourself the ammunition to defend it. Other than cap rates, the most common valuation tool is to look at comparable properties in the market that have recently sold and determine their sale prices on a per unit and a per square foot basis.
The Offering Memorandum you’ve received will very likely have these comps included.
I would use them for guidance but I would STRONGLY caution against relying on the seller's comps as your sole source of information.
I guarantee the asking price was locked down well before the comparable sales were selected. Therefore, those sales are hand-picked to justify the ask price, not your offer price. You can use software such as Costar, Reonomy or whatever you use, to pull sales yourself in the immediate market. Most county appraiser sites will even allow you to search by most recent sale date as well for free. Just be sure you’re spending a few minutes making sure these comps you’re using are actually comparable in age, size, unit mix, location, etc.
Once you’ve gathered these comparable sales, look at their prices compared to your pending offer. If your offer is falling within a per unit/sf range of actual sales, you’ve got a solid case when submitting your LOI. If your offer is coming in excessively higher or lower than these sales, take a closer look. Maybe the property justifies being higher or lower but, if you’re in a reasonably-sized market with active sales, you should look at comparables that match your target property’s characteristics and make sure you’re in that range.
At this point, you’ve adjusted the numbers, determined your offer price and confirmed you aren’t overpaying or offending anyone with your offer. If the seller accepts your offer, you can move forward confident that you’re buying a property that should perform as you underwrote and will hopefully be a successful investment for you and your partners. If the seller rejects your offer, that’s fine as well. You never want to overpay by assuming financial projections that can’t be met or using cap rates that don’t allow you to achieve the yields you need. There are other opportunities on the horizon. Don’t get suckered into a bad one.
Go out, find your deals and cover your ass! Good luck!
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Next: Summer Series will be announced early June!