DON’T FALL INTO THE CAP RATE TRAP
By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
“Are you kidding me?” my client asked. “You’re telling me that the property taxes are going up by $19,500 when the county reassess the property I’m buying based on the purchase price after I own it?”
“Yes”, I answered. “In California they do that.”
“Well then”, he said, “ that means I’m buying the property for a 4.70 cap instead of the 6 cap the listing agent said it was. That means I’m getting ripped off and the listing agent lied to me. Why would he put the seller’s lower property taxes in the list of expenses and calculate a 6 cap? This is the only property I’ve identified in my 1031 exchange. What am I going to do?”
I was in the process of starting a loan for this client. We did some research online with the county and found out what his property tax would soon be after the sale went through. He was thankful to know, but mad as hell at the seller. When the buyer found out the property was netting so much less he tried to convince the seller to lower the price so that he would still be buying at a 6 cap. The seller, knowing that it was a sellers market would not do so and my client eventually had to buy another property that was not identified in his 1031 exchange and pay the capital gains tax he was trying to avoid in the first place. This is an example of how misrepresenting, or not knowing the accurate cap rate can really do a lot of damage. In this case, the listing agent in the offering memorandum did list the property as being sold at a 6 cap. Whether or not the listing agent meant to mislead the buyer or was just not being meticulous, is not the point. The point is that until you do your due diligence on the income and expenses of the property you are not going to know for sure exactly what the cap rate of the property is. To my client it meant that he was getting a 1.3% lower rate of return on the purchase price which computed to $19,500 less in income annually from the property then he expected. This true story illustrates how my client fell into the first pitfall in the cap rate trap: When Buying – Assuming the Cap Rate is Accurate.
Keep in mind that Cap Rate or Capitalization Rate is the most important number when buying, selling or refinancing a commercial property. Cap rate is simply the annual net operating income of the property divided by the property value. So the lower the cap rate, the lower the annual rate of return on the value of the property. The higher the cap rate, the higher the annual rate of return. But more so, this number represents the percentage of the investment that the owner of the property will be earning based on the appraised value or purchase price. The simplest way to understand why cap rate is so important is to think about investing money in the stock market or an annuity. Besides the safety of the investment, the most important thing to you is how much annually are you going to earn. If the number is 6% or better you are likely thrilled. A higher number is better than a lower number. The same is true for cap rate. We have already illustrated why computing the cap rate accurately is so important when buying a property. You certainly do not want to pay more than a property is worth, and cap rates represent what other like investment properties are selling for – so this is really important. When an income property investor looks for commercial properties to purchase, they always have a minimum cap rate in mind which represents whether or not this is a good deal based on the purchase price and net income. When an income property investor is selling a property, they also look at market cap rates. What are the current cap rates on similar properties? They certainly want to sell at the lowest cap rate supported by market sales. They want to get the very best price based on prices other investors have received. When an investor is refinancing their commercial property, they also need to get an accurate idea of what the property will appraise at before they go through the money and time to apply for a loan. Keep in mind that commercial appraisers rely on cap rates to determine the property value in the income approach of the appraisal.
The Three Cap Rate Pitfalls to Avoid
- When Buying – Assuming the Cap Rate is Accurate
- When Selling – Overselling The Cap Rate
- When Refinancing – Being Burned by a High Cap Rate Bad Appraisal
1. When Buying – Assuming The Cap Rate Is Accurate
When you are selling a used car you will likely put the car in its most attractive state. The buyer will see the beauty of the car first and might not even bother to look under the hood.The same is true for many realtors and sellers of commercial properties. Not only will they clean the property up and give it a coat of paint, but often they will give a coat of gloss to the line by line income and expenses to enhance the net operating income and thus show a higher cap rate.They won’t think of this as lying or misrepresenting what they are selling.They think it is ok to sell the property based on its potential.But this is a business!Would you buy a business based on its potential?No, of course not.You will only buy it based on what it is actually netting.Listing agents will often put together an offering memorandum with some actual numbers, and some pro forma or projected numbers. Unfortunately, this will likely result in the property being offered at a higher cap rate then it is actually running at. Remember, higher means you are getting a better deal.So always go into the negotiations assuming that the cap rate has been enhanced.The most reputable listing agents will identify which numbers are actual and which are estimated.But be sure to negotiate a short initial period (one – two weeks) where the seller has to provide you with property financials so you can accurately determine the annual income and expenses and the actual cap rate. Be sure to collect these items and follow these steps:
- Collect a current rent roll
- Compare the gross income on the rent roll with actual collections showing on the income and expense statements. Just because someone is renting a unit does not mean they are paying rent. You need to determine what the economic occupancy is, not just the physical occupancy.
- Collect the last two full years and current year to date income and expense statements. It is important to know how the property has performed historically. Again, this is a business. Wouldn’t you rather buy a business that has more than a few months or a year of good sales and income?
- Request the past trailing 12 months income and expense statement (if you can get it). This is what a lender will need. The most important thing to the lender is to know how the property has done over the past year.
- Determine actual property taxes. If you are purchasing in a state that increases property taxes based on the purchase price, find out what the milleage rate is and multiply this by the purchase price. This will give you the correct property tax expense for this to be used in computing the cap rate. And yes, this will be higher than what the seller is paying. If you are purchasing in a that state does not increase taxes based on the new purchase price, be sure to still check with the county to see what the current taxes are. They might have gone up recently and the seller and/or listing agent may not have known this.
- A list of all the capital improvements made in the last 5 years. Capital improvements are items like a new roof, new appliances, a resurfaced parking lot – items that are not just repairs but are replacements. The IRS expects property owners to not write these off on their taxes. These should not show as expenses but often are.
- A list of all deferred maintenance items. This will tell you if the maintenance and repair expenses are low because the seller has not been spending the money necessary. If so you will need to add more to your annual cost projected for this expense. If this seems like a good deal because the cap rate is quite high the property likely needs a lot of work.
- The Seller’s Schedule E’s. If the income or expenses seem inaccurate, ask to see the seller’s schedule E’s from his taxes. This will tell you how he reported the income and expenses to the government.
- When you calculate cap rate be sure to include market vacancy or 5% even if the property is full, and replacement reserves of at least $250 per unit per year. The appraiser and your lender will do this and it is standard practice in computing cap rate.
- If this is an office building or retail building be sure to include the expenses for tenant improvements and leasing commissions.
- Make sure that the seller has given you a complete list of expenses.
Below is a chart you can use:
|ANNUAL INCOME||YEAR TO DATE||LAST YEAR|
|TOTAL SCHEDULED RENTS (100% OCCUPIED)|
|ACUTAL RENTS COLLECTED|
|TENANT REIMBURSED EXPENSES COLLECTED|
|OTHER COLLECTED (Laundry, Garage, Misc.)|
|TOTAL INCOME COLLECTED||$0.00||$0.00;|
|FIXED ANNUAL EXPENSES|
|REAL ESTATE TAXES|
|OTHER TAXES AND ASSESSMENTS|
|FUEL / GAS|
|WATER & SEWER|
|BUILDING MAINTENANCE & REPAIRS|
|INTERIOR & EXTERIOR DECORATING|
|PARKING AREA MAINTENANCE|
|LEGAL & AUDIT|
|REPLACEMENT RESERVES (Non-Recurring Expenses)|
|CARPET / DRAPES / BLINDS|
|APPLIANCES / FURNITURE|
|HEATING & AIR CONDITIONING|
|TOTAL EXPENSES & REPLACEMENT RESERVES||$0.00||$0.00|
2. When Selling – Overselling the Cap Rate – It is so tempting to oversell the cap rate. After all, the property does have the potential to achieve this. If you are the seller or listing agent and whether knowingly or unknowingly you portray the cap rate inaccurately consider that there will be consequences. Do your due diligence following the same steps in number one that the buyer will use. After all, if you put up the property for sale stating a lower cap rate then the actual cap rate, this will likely come back to bite you – the sale can crash and burn. Just follow these simple steps:
- As a seller, do not let your realtor oversell the cap rate by convincing you that the market is so good that he can sell the property for you based on pro forma income or expenses. Always insist that your realtor use actual numbers. If he wants to use a pro forma to show potential rent and/or some improved expenses that is fine as long as he states clearly in the offering memorandum, which numbers are not actual and that only actual numbers are used to calculate the cap rate.
- Be sure to include market vacancy and replacement reserves in your expenses. Keep in mind that appraisers and lenders always do this and a savvy buyer will too.
- If this is a fixer upper or an opportunity for someone to buy your property and reposition it (fix it up and raise the rents), then it is ok to have your realtor show the current actual cap rate and the potential estimated cap rate based on when the renovations and rent increases are in place.
3. When Refinancing Being Burned by A HIgh Cap Rate Bad Appraisal – Commercial appraisers certainly do not like to admit that their reports might not be totally accurate. But the truth is that an appraisal report is not always based on exact research. These reports can be and often are convoluted. The appraiser can choose which comparables they want to include in the report and which they want to exclude and thus influence the valuation one way or another. When you refinance your commercial property, you do not get to choose the appraiser, the lender does. Think about it, the appraiser wants to get hired again and does not want to have his report challenged by the lender. So the appraiser will often deliver an appraisal to the lender that they know will be accepted. I know this is a harsh statement for me to make and any commercial appraisers reading this will discredit me on this. But with my over 20 years of experience as a commercial mortgage banker and broker and reading hundreds of appraisals, I have seen this too often to be the case.
On one extreme we have community bank appraisers. They almost always seem to be the most conservative and may compute the cap rate in the income approach as being up to 1.00% higher than what the property would sell for.They do this by using higher cap rates and lower rent comparables in the income approach.Understand thatcommunity banks really got hurt after the great recession of 2008 when property values fell.They got in trouble with federal regulators because many of their commercial loans had the loan to values increase beyond acceptable limits.The banks were often forced to get these loans off their books by lowering the principal balances and demanding that their valued customers refinance elsewhere.
On the other extreme we have CMBS,Fannie Mae and Freddie Mac appraisers who have the tendency to be on theliberal side of property valuation.Their cap rates will be computed with higher rents and cap rate comparables in the market. Community banks, national banks, and life company appraisers are often in the middle on valuation and thus more accurate.
So as a commercial property owner, you likely have an idea of what your property is worth based on its actual income and what other like properties are selling for in your neck of the woods. When applying for a refinance loan I recommend that you do the following to avoid falling into the cap rate trap:
- If you are applying for a loan with a community bank do some research first with a commercial realtor to determine what they think the value of your property is. Share this data with your bank at the beginning. Getting you bank behind the value first and getting them to accept that maybe cap rates have come down can only help you. And at a minimum, it might influence them to value the property more accurately.
- If you need a certain amount of cash out in your refinance (banks rarely allow this), and you are concerned that the appraisal might come in too low to support this, consider having a skilled commercial mortgage broker like Apartment Loan Store submit your loan. We know which loan programs and lenders use more liberal appraisers, and will help you hit a home run.
By Terry Painter/President Apartment Loan Store and Business Loan Store