Cap Rates and Financial Manipulation
There are three numbers that determine a property's performance or value. These numbers are the NOI (Net Operating Income), Cap Rate, and Value.
The Golden formula is:
NOI/ Cap Rate = Value
However, any two of these figures can be switched around to get the third. Variations are shown below.
NOI/ Value = Cap Rate or Value x Cap Rate = NOI
In commercial real estate, these figures determine a property's price tag (value) based on the property's performance (NOI) and its comparative return (Cap Rate). So, what is the cap rate?
Cap rate is the return a property would earn if it were owned outright (no debt). Another way to say this is cap rate measures how much a business earns. In our case, it is how much an apartment community earns.
It is also a measurement of risk. A lower cap rate is a less risky asset whereas a higher cap rate is a riskier asset. Lower risk, lower return. Higher risk, higher return.
The cap rate for a geographical area is determined by the market. An accurate local cap rate can be found by asking local brokers, reviewing Costar and Yardi reports, asking other investors, and asking lenders. It's a good idea to check multiple sources for the cap rate as often one source may not be entirely accurate.
Even though the cap rate is a given figure determined by the market, it can still be manipulated. An inaccurate cap rate will skew the value of the property and its performance.
The cap rate itself is not necessarily manipulated, however, the conditions surrounding it are. The external market is ever-changing and as such, cap rates fluctuate. Now, real estate is not a liquid asset and so when there are fluctuations in the market, they happen very slowly.
Cap rates either expand or compress. They expand when market conditions are bad and compress when market conditions are good. Currently, interest rates are rising rapidly and the cost of capital is increasing dramatically which is causing cap rates to expand for the first time in nearly 20 years.
The problem is, when cap rates are compressing, it is much simpler to hit projected returns because the value is dramatically increasing regardless of performance. This is worrisome because poor operators are then rewarded for underperforming. The way to determine if an operator hit their projections or only rode the wave is by analyzing the final numbers.
Specifically, comparing the projected NOI to the final NOI. If the final NOI is the same as or higher than the projections, then they did their job well. If the final NOI is substantially lower than projections, then its bad news.
NOI is just as important as the cap rate for these multifamily properties. Although, unlike the cap rate, NOI can be falsified in many ways and very easily. Since the value of the property is determined by the NOI/ cap rate, then the higher the NOI, the more a property is worth. If brokers or sellers are able to make it seem like the NOI is higher than it actually is, they'll make more money. This is where it is critically important for operators and investors to do their own underwriting.
First, let's review NOI. NOI is all the income, minus all the expenses, not including debt. NOI can be manipulated in either the income, the expense sections, or both.
In the income section, NOI can be manipulated by having concessions (such as one-month free rent), adding in extra additional income, not accounting for bad debt (nonpayment that will not be recovered), and or other similar ways. Brokers may also try to fluff up proforma NOI by using the highest rent comparables they can find which might not be justified or accurate.
The expense section is where NOI can be dramatically changed. Brokers and sellers will notoriously not include or underestimate very important expenses such as repair and maintenance, reserves, property management, legal fees, unit turns, etc.
The two most important expenses to verify are taxes and insurance. When a property is purchased, it is almost guaranteed that taxes and insurance will increase. It is essential to account for these decreases in NOI and therefore property value.
Ensuring a property is purchased with accurate underwriting (NOI and cap rate), the owner and operator will have a great journey and much success. Although there may be a lot of manipulation in the space it is just as simple to see through it and determine the proper values.