Cap Rates and Lender Risk

Cap Rates and Lender Risk

Beach, Rex

Q: What is the relationship between an income-producing property’s assumed investor return and the level of risk assumed by a lender providing financing?

A: Before getting to the heart of the question, its important to define capitalization rate or the required rate of return. In simple terms, it equals net operating income divided by the acquisition price of an income-producing property. Thus, if we know the net operating income for a recently acquired incomeproducing property, we can quickly compute the cap rate by dividing the property’s net operating income by its acquisition price.

For example, let’s assume that 2005 net operating income for a small office building in Modesto, California was 585,000. The property sold in early January 2006 for \$1,416.666. The cap rate, therefore, is 6.00 percent (85,000 /1.416.666) = .06 or 6 percent. In other words, the investor paid \$1,416.666 for an annual stream of income of S85.000 that represents a 6 percent rate of return for him or her.

There is one critical assumption that we need to acknowledge, The stream of income purchased by the investors is a stream that continues perpetually. By applying the investors required rate of return, the stream of income is capitalized or converted to an asset value.

However. the stream of income from income producing properties is not risk free or highly liquid. Given this situation, we would expect that the required rate of return for income-producing properties would always exceed the required rale of return for a Treasury note or a bank CD, However, this assumption might not always be true. The investor in a Treasury bill, bank CD, or corporate bond knows the exact amount he or she will receive at maturity. Hut the ground shifts for the Modesto property investor.

First, the investor is uncertain about the property’s stream of income. second, the investor is uncertain about the maturity date of the investment (date of resale) or the value of the investment at maturity So why doesn’t the cap rate reflect these two elements of uncertainty, which appear to increase risk?

There are relatively simple explanations. The investor may, in acquiring ihe Modesto property, expect:

* To increase rents and, therefore, increase net operating income;

* To decrease vacancy rates and, therefore, increase UL-I operating income; or

* To decrease operating expenses and. therefore, increase net operating income.

Any combination of these three events, leading to an increase in the investors stream of income, increases the rate of return. For example, if net operating income increased to just \$90,000. the cap rate would increase to 6.35 percent.

The upside to uncertainty about market value at maturity is a possible increase in that value, perhaps still possible in some markets. Consequently, a 6.35 percent rate of return, complemented by a 15 percent appreciation in asset value over a short period of time, sums to a very nice return on investment.

But there are some potential problems. Rents may not increase, nor vacancies and expenses decrease. Further, accurately predicting appreciation in real estate values is a tricky business.

We’ll likely survive, nicely as lenders if we honored our underwriting standards going into the deal. For example, if we held to a loan-to-value maximum of 0.75, we would have provided no more than \$1.062.500 toward the Modcsto property acquisition price of 51,416.666.

But if we held, as well, to a minimum 1.25 debt service coverage, we run into trouble. \$1,062,500 of long-term financing at a 7.00 percent interest rate, amortized over 25 years, translates to a bit more than \$91,000 in annual debt service. That exceeds the property’s net operating income of 585,000. which is the amount available for debt service. We, and the borrower, would be underwater at that level of market value, financing, and debt service.

So we might beware those relatively marginal cap rates and all they imply about coming events, unless we can peer flawlessly into the future.

Beach will be the facilitator for ACB’s new blended learning course “income Producing Properties,” which kicks off with a Webinar on March 6. 2007. For more information and to register, visit ACB’s Website.

If there is a question that you would like to see featured in this column, please contact fames Swann at jswann@acbankers.org

REX BEACH, founder and managing director, Shockproof! Training; E-mail: RexBeach@shockproofirainmg.com

Copyright America’s Community Bankers Jan 2007