Income, Capitalization Rates, IRV, and Real Estate Investment Analysis

by Howie Gelbtuch of Reis

Background

Few terms are so simple yet so misunderstood as capitalization rates, or "cap rates" as they are usually called.  In a prior column, we described a capitalization rate as "income divided by value."  Indeed, the current edition of The Dictionary of Real Estate Appraisal, published by the Appraisal Institute, defines a capitalization rate as:

Any rate used to convert income into value.¹

Seems straightforward enough.  Those readers of baby boomer age or older (born between 1945 and 1964) probably remember the universal valuation formula known as "IRV": Income divided by Rate equals Value.  But like many things in life, capitalization rates have become far more complicated over time.  Let's take a closer look at the two components of a capitalization rate.

What to Capitalize

In simpler days, "income" referred to net operating income or NOI.  This was generally regarded as Effective Gross Income (Potential Gross Income from all sources less a vacancy and credit loss allowance), less all Operating Expenses (including the property management fee, real estate taxes and insurance).  Specifically excluded from the calculation were a reserve for replacements, tenant improvement costs, and leasing commissions.  The theory behind these exclusions was their tendency to distort NOI in a given year when substantial one-time capital repairs were required, or significant amounts of space were rolling over, necessitating large amounts of re-leasing costs that distorted that year's income.

Reflective of the current confusion in the market, one widely read investor survey currently describes NOI as either income after capital reserves but before tenant improvements and leasing commissions; or before all capital reserves, tenant improvements, and leasing commissions; or after all capital reserves, tenant improvements, and leasing commissions.

And a publicly traded real estate investment trust investing in multifamily properties defines income as NOI (after payment of a property management fee) less a stabilized reserve per unit, for the first 12 months following the date of the valuation.  While it has certainly become increasingly common to base a capitalization rate on anticipated income, in the bear market of the early 1990s, the convention was to capitalize income in place (existing income), and pay an additional sum to the seller if property performance improved, known as an earn-out.
 
Most of the capitalization rate inconsistencies are applicable to the office and retail sectors.  (As industrial buildings are typically net leased, there is less uncertainty associated with estimating income.)  For apartment properties, the most common approach is to deduct only a replacement reserve (usually $250-$400 per unit) from NOI to arrive at an agreed upon income amount.  For hotels, most buyers will look at forecast rather than historical income, but the consensus is not as uniform as within the other property sectors.

Variations in Capitalization Rates

While internal rates of return (IRRs) have fluctuated significantly over time, depending upon market conditions, interest rates, and especially inflation, capitalization rates have tended to remain more stable.  For example, in 1981 a pre-sale analysis used to derive the asking price of a Manhattan office building at 342 Madison Avenue contained the following assumptions:

The IRRs used to value the property varied from 14.0 percent to 18.0 percent, extraordinarily high by historical measures, yet the initial year capitalization rates, based upon net operating income before a replacement reserve, tenant improvements, and leasing commissions, were a far more reasonable 7.0 to 10.0 percent.  Note that while IRRs are certainly lower today, probably between 9.0 and 12.0 percent for most Manhattan office buildings, capitalization rates generally remain in the same 7.0-10.0 percent range that they were more than 20 years ago.  

Why the disparity?  With inflation of two to three percent today, real rates of return are about 7.0 to 9.0 percent.  In the early 1980s example cited above, with inflation of approximately 7.0 percent, real rates of return were about the same or slightly higher. 

The risk level associated with investing in bonds rated BBB was once thought to approximate the risk of investing in real estate, as measured by IRRs.  Both bonds and real estate have similar payment characteristics, a series of annual interest payments/cash flows, followed by a return of principal/property reversion.  However, this relationship no longer appears applicable as illustrated in the next table. 

Thus the capitalization rate, which represents an investor's minimum required first year rate of return, regardless of the IRR, has held comparatively constant, although it has clearly trended downward over the past few years.  Beyond certain obvious reasons, such as an expected dramatic near-term increase in income (recall that Manhattan's Pan Am Building sold in 1980 at a capitalization rate of 3.4 percent and an IRR of 10.0 percent in anticipation of a near-term spike in rents), there are still sub-currents at work that affect capitalization rates. See observed recent trends.

Additional Capitalization Rate Observations

OFFICE MARKETS

Investors are of course willing to pay more dearly for markets perceived to be the most desirable.  Consider the following capitalization rate data extracted from a Reis database of comparable office building sales.

Whether it is the supply-constrained nature of the Washington, DC office market, or the perceived long-term allure of Manhattan, these two office markets typically command capitalization rates at the low end of the spectrum of office buildings in the United States.  Understandably, office buildings in the suburban Maryland market, characterized by a higher availability of space, frequently trade for a higher capitalization rate than their more urbanized counterparts in Washington, DC.  
 
MULTIFAMILY MARKETS

New York City's multifamily market is unique in the United States.  New York City differs from most of the nation in many respects, including the fact that most New Yorkers do not own the homes in which they live.  According to preliminary results from a recent Housing and Vacancy Survey (HVS), the percentage of rental units relative to all dwellings in New York City is approximately 65 percent, twice as high as the nation as a whole.  In addition, unlike most cities, the bulk of rental units in New York City are rent regulated.  Of the nearly 2.1 million occupied and vacant available rental units reported in the most recent HVS, only a third (33 percent) were unregulated, or "free market."  The HVS also indicated that the New York City housing market remains tight, with a citywide vacancy rate of 2.9 percent in 2002, well below the 5.0 percent threshold required for rent regulation to continue under state law.

Recent capitalization rate data indicates the following:

Surprisingly, these capitalization rates are within the range of cap rates for more traditional, suburban multifamily apartment complexes nationwide.  Note that they are also lower than for most office buildings, possibly reflective of the theoretical ability to raise rents annually as leases expire, as well as an expected increase in interest rates which will benefit rental apartment building owners by making single-family home ownership less affordable.  However, given the complexities of owning and operating a residential rental project in New York City, as well as the potential upside once (and if) a rent regulated tenant has vacated a building, it is not surprising to see sales of buildings at capitalization rates far lower than those cited here, especially in Manhattan.

Furthermore, many buildings of this type trade as a multiple of gross income, rather than on a capitalization rate (net income) basis.  Of course, this then raises the issue of how to define gross income, and whether to use potential gross income (before a vacancy and collection loss allowance), or after, defined as effective gross income.  Rather than a single, correct answer, consistency is the key to accurate analyses, whether dealing with gross rent multipliers or capitalization rates.

Incidentally, we define capitalization rates as income after capital reserves but before tenant improvements and leasing commissions.  This is consistent with our observed macro trend towards inclusion of a deduction for a replacement reserve, despite the fact that we've yet to meet an office building or shopping center owner that actually sets aside money each year.

Outlook

Depending upon whether one is a seller or a buyer, this has been both the best of times and the worst of times.  Many sellers have found the compression in capitalization rates to be irresistible.  A building with $4 million in income capitalized at 8.0 percent yields a price of $50 million; at 7.0 percent, the price for the same building is in excess of $57 million, an increase of 14 percent.

This has caused many to question whether the decline in capitalization rates is cause for alarm.  Is it being caused by a favorable outlook for real estate, or as we used to say 20 years ago "too many dollars chasing too few properties?"
There is little doubt that capital flows into real estate investment trusts, for example, are stronger than real estate fundamentals.  Capital flows into real estate mutual funds reportedly set a record in 2003: $4.3 billion not only exceeded the $3.4 billion in net inflows in 2002, but also surpassed the previous record of $4.1 billion in 1997.  Many of the dollars going into REITs are coming from overseas.  While US investors seem to be getting a bit skittish about the run up in REIT prices, the Australians, among others, have remained enthusiastic about investing in the US, driven by a lesser-developed financial market and fewer opportunities at home.

Most importantly, in our current low interest rate and low inflationary environment, there seems to be little cause for alarm that capitalization rates have become dangerously low.

Perhaps a return to a simple price per square foot analysis is now in order, if only we could all agree on how to measure a building.

¹ The Dictionary of Real Estate Appraisal, Fourth Edition, 2002, Appraisal Institute, Chicago, page 41.