Real Estate Metrics: Numbers Never Lie or Do They?
What are the Important Real Estate Metrics and Why Do They Matter?
Thomas F. Kaufman
General. Real estate has been a key component of everyday life since the adaptation of mankind into an agrarian society thousands of years ago. While not as high tech as flash trading and Silicon Valley businesses, it is still data driven. Can I rent this property and for what amount? What are competing rents and sales prices? What are financing costs for this class of property? Will additional tenant improvements generate a sufficient return to make the investment worthwhile?
Metrics are imbedded into all aspects of real estate, not just at the basic property level as above, but as an overall guide as to how real estate compares to other investment classes.Most importantly, without numbers how do you measure real estate risks and rewards to see if the return is sufficient given the underlying risks?
Lawyers in general have often been thought of as weak in quantitative skills[1]. While recent articles have indicated that is not true[2], why would a lawyer be interested in the underlying metrics?. The primary reason tounderstand the metrics is that it helps a lawyer to better comprehendthe client’s goals for a project . It also helps define what is important in the legal context because if it is importantto the economics of the client’s activity, then it should be protected in the related legal documents.
A more basic reason to use and review metrics is to understand risk and its rewards in connection with any investment. Without numbers there are no odds, no probabilities and no measures and the only way to assess risk is to trust in the “Gods and fate.”[3] While seat of the pants intuition is often very helpful, more detailed modeling of risk and returns is more insightful. Nevertheless, two things should be recalled. First, the best spreadsheet does not yield the best investment decision, otherwise creativity and business acumen would give way purely to spreadsheet sophistication. Second, no spreadsheet is ever 100% accurate. They are based on projections for things such as income and expenses and while they may be close in the aggregate returns sometimes, they are virtually always wrong on the minute details of the projections.
- The Basics.
Present Value. The most fundamental concept in modeling is present value. The idea that a dollar today is worth more than a dollar in the future is the basis for determining present value. In most investments the steam of income will continue for many years from the initial investment to the ultimate sale. If a dollar today can be invested at 5 percent per annum, it will be worth approximately$1.63 in ten years. If the interest is compounded monthly then the same 5 percent per annum will yield approximately $1.65 in 10 years. To determine the correct discount factor to apply one must be able to calculate the percentage return an investor would require in order to accept the delay in the payment. That judgment is based upon (i) the nominal interest rate for a similar time period, (ii) the perceived inflation rate, (iii) the risk that the payments will not be made as required, and (iv) the simple supply and demand for money. As these figures vary constantly, the discount rate should also vary, but most times it is chosen as a constant over the entire period. For a more detailed look at present value and choosing the discount rate see Understanding Real Estate Economics[4].
The present value of $1,000 is shown in the following chart
Present Value of $1,000 for Different Time Periods at Different Discount Rates
Rate / Years / 5 / 10 / 15 / 205% / $783.53 / $613.92 / $481.01 / $376.89
10% / $620.92 / $385.54 / $239.39 / $148.64
15% / $497.18 / $247.18 / $122.89 / $61.10
- Cap Rates – Oh What a Price We Pay: A Slightly Different Perspective.
2.1 Introduction. Cap Rate is a widely misunderstood concept. The Cap Rate was developed and flourished in the era prior to computers as a way to value the income stream from an asset to derive a fair market value. In simple terms, the fair market value was determined as below:
Fair Market Value = Stabilized Net Operating Income / Cap Rate
In this equation, the Stabilized Net Operating Income is the best estimate for the net operating income (“NOI”) after whatever rehabilitation, re-tenanting or project stabilization was completed. The Cap Rate is the minimum rate of return that the investor demanded from this specific investment considering the entire investment, including the risk profile of the investment. Cap Rate then becomes a determinant of what price the market will pay for an asset.
Cap Rate = Stabilized Net Operating Income / Fair Market Value
So if a property has $1,000,000 stabilized NOI and the Cap Rate is 5% then the investor would pay $20,000,000 for the asset ($1,000,000 / .05). This calculation has the virtue of simplicity even if based upon limited due diligence and all diligence going into determining the stabilized NOI. Obviously income and expenses change over time in complex manners, so this simplistic approach is not very insightful in these days of powerful computers and computer models.
The continuing appeal of Cap Rate is that it is a shorthand way to specify the level of pricing and expected returns for investors. In today’s world where the average smartphone is more powerful than a main frame computer in the early days, there are many methods of determining theprice for an asset. The most widely used is the Discounted Cash Flow model, which will be discussed in moredetail later. Not only that, but most purchasers consider at least 5 to 20 metrics in determiningrates of return and proposed pricing.[5]
2.2 Market Shifts. Cap Rate is also useful for determining what happens when markets shift and pricing changes accordingly. For example, in the early 2000s the pricing for many major hotels was based upon a Cap Rate in the 10-11 percent range. Today that Cap Rate is about 4.5 to 6 percent for major hotels in major gateway cities. A rise in the Cap Rate can be driven by many items. Most importantly is the perceived inflation and overall interest rates. As interest rates rise, so must Cap Rates. No one would invest in the equity of an investment if the return were less than that of debt. The rate of return on an equity capital investment must be perceived as greater than that of debt on the same assetin order to make up for the increased risk of equity ownership. That is a basic law of finance. Thus there are times when the change in Cap Rate is driven by an increase or decrease in interest rates.
The past several years have seen unusually low rates of interest with 10-year US Treasury securities in early 2015 dipping below 2% per annum. That is below their long term norm. What happens as interest rates and Cap Rates increase? As Cap Rates rise, then under the formula above, the fair market value will decrease unless the NOI is increased. It is instructive to look at how much the NOI must increase based upon Cap Rate increases to maintain pricing stability.
Required Increase in NOI as a percentage to maintain constant Fair Market Value given an increase in Cap Rates:
Percentage Change in NOI to Maintain Same Fair Market Value[6]Cap Rates
Old / New / 5% / 6% / 8% / 10% / 12%4% / 25% / 50% / 100% / 150% / 200%
5% / 20% / 60% / 100% / 140%
7% / 14% / 43% / 72%
9% / 11% / 33%
10% / 20%
Obviously, under the table above, an increase in Cap Rates from 4% to 5% requires a 25% increase in NOI to prevent a decrease in price. How does an owner achieve the 25% increase in NOI? Assuming the sale time is at least 5 years out that means the owner must increase NOI 5% a year or 4.55% compounded annually for the 5 years. If that Cap Rate shift occurs over 2 years,then achieving the 25% increase on NOI in 2 years may be nearly impossible, so the owner may simply hold the asset longer until it achieves a bigger increase in NOI. An increase from 4% to 6% (which is low by most historical standards) requires a 50% increase in NOI (10% per year or 8.5% per year compounded annually). In most markets getting that roughly 10% increase per year from rent is not likely to be achieved. It also should be noted that these increases would only bring you back to the price you paid for the property. Most purchasers today are accepting annual cash returns per year much less than the Cap Rate and putting great emphasis on their refinancing orfinal sale to give them a major part of their overall profit on a project.
Another factor to consider is that today’s low Cap Rates mean that in modeling a sale you have to pick a Cap Rate on the outgoing sale that is most likely higher than you used in your purchase. As shown in the examples above, to get the same fair market value on a sale it means that the purchaser must assume a relatively large increase in NOI or possibly show a loss on the ultimate sale of the property. Many purchase models seem to assume that Cap Rates will move up but not that much, but obviously if that model is wrong and Cap Rates increase substantially, then the sales price will be dramatically reduced.
Likewise a decrease in Cap Rates can dramatically improve the sales price of a real estate asset, even if cash flow is relatively stable. A decrease in Cap Rate from 5% to 4% generally increases the sales price of an asset by 20%, assuming the NOI remains constant.
In summary, the history of interest rates and Cap Rates has been volatile, and that is expected to continue.[7] With interest rates at very low levels, it is expected that interest rates will increase in the future and Cap Rates will rise with them.[8] The change in Cap Rates will echo in pricing and buyers in 2015 have to take that into account in planning refinancings and final sales.
2.3 Holding Period. There is a corollary that is especially important with low Cap Rates that are expected to increase -- that if you hold the property for a very, very long time, then the ultimate sales price on the Discounted Cash Flow model will not be as significant as it is for the buyer who intends to sell the property within 5 years. In that case, the Cap Rate at the time of the distant sale will not be as large a factor. For example, if you are selling an asset in year 5 for $10,000,000 and the discount rate is say, 12% per annum, then the discounted cash flow (present value) for a sale after 5 years is $5,674,269, whereas if the asset was sold after 25 years, then the discounted cash flow (present value) of that sale is $588,233, only about 10% of the magnitude of the sale price after 5 years. Now obviously the sale price should increase over the 20 years from year 5 to year 25, but even if the value of the asset increases 3% per year, the discounted cash flow (present value) of that increased price ($18,061,112 in year 25) is still only $1,062,414. This is very small compared to the impact on the discounted cash flow of a sale in year 5.
Conversely, in times of decreasing Cap Rates and therefore increasing prices, a shorter holding period may allow an assumption in the underlying models that on the sale date the Cap Rate will decrease even more and thus the shorter term hold would be benefitted.
For example, assume one bidder is looking to hold a real estate asset for 3 years and another bidder for 10 years and the asset is worth roughly $14,285,000 and has a roughly $1,000,000 NOI. Assume that the Cap Rate at the time of the bidding is 7%, but is trending lower because of low inflation, an improving economy and high demand for real estate. Also assume a 12% discount rate for the discounted cash flow. Maybe the bidder with the 3-year hold can project a Cap Rate of6%, whereas the longer term hold cannot justify saying there will be any change in the Cap Rate. Then assuming a sale at the end of 3 years at a price of $15,600,000 (a 3% per year increase), the present value of the sales proceeds would be $11,103,771, whereas for a sale after 10 years, the present value of the sales proceeds would be $5,215,322 ($16,198,000 (which is the acquisition price $14,285,000 growing at 3% per year) / 3.106 (the discount factor after 10 years at a discount rate of 12%))
2.4 Moody’s Cap Rate Adjustments In its October 29, 2014 Special Comment, Moody’s Investor Service stated that “Conduit Loan Credit Quality Slippage is Déjà vu All Over Again.”[9] It is an excellent analysis of the CMBS market, and it concludes that the Moody’s loan to value ratio (“MLTV”) for CMBS collateral for the 3rd Quarter of 2014 is not the 67.8% that the underwriters show, but that it is really 112.2 %[10]. In simple terms how can you arrive at that conclusion? One simple way is to assume that the NOI is accurate, but that the underwriter is using an aggressive Cap Rate to justify higher property values.
Let’s use an example. Assume the underwritten stabilized NOI for a property to be financed is $1,000,000 per year and use the Cap Rate cited by Moody’s as the underwritten Cap Rate of 6.37% used on this property. Then using our formula for the fair market value and Cap Rate
Fair Market Value = stabilized NOI / Cap Rate
$15,698,587 = $1,000,000 / .0637
The underwritten fair market value is then roughly $15,698,587. If the loan to value ratio is approximately 67.8% then using the formula for theLTV
LTV = Loan Amount / Fair Market Value
Loan Amount = Fair Market Value * LTV
Assuming the LTV = 67.8% then the Loan Amount would be approximately $10,643,641
$10,643,641 = $15,698,587 * 67.8%
But the Moody’s cap rate would be roughly 350 basis points higher[11], or approximately 9.87%,so it would calculate a different fair market value and different LTV using the exact same stabilized NOI. Let’s look at the Moody’s calculations:
Fair Market Value = stabilized NOI / Cap Rate
$10, 131,712 = $1,000,000 / .0987
So theMoody’s LTV using the Moody’s Cap Rate and Moody’s Fair Market Value, but the underwritten loan amount of $10,643,641 would be:
Moody’s LTV = Actual Underwritten Loan Amount / Moody’s Fair Market Value
105% = $10,643,641 / 10,131,712
So the Moody’s LTV would be 105%, whereas the underwritten LTV was stated to be 67.8%. Obviously the Moody’s LTV of 105% is still less than the average Moody’s LTV for the 3rd Quarter of 2014, 112.2%, but that difference can be attributed to adjustments in underwritten NOI or other factors. The important thing to note is that the announced underwritten LTV is a relatively conservative 67.8%, whereas Moody’s thinks the underwriting is far too aggressive and the real Moody’s LTV is over 100% of the fair market value. Most of that difference can be accounted for by Moody’s implied restatement of the Cap Rates to take into account Moody’s belief that the aggressive pricing in the real estate market and resulting low Cap Rates are not true long term indicators of value and need to be adjusted to properly assess the finance risk.
Most importantly, Moody’s believes that there are inherent risks to the entire CMBS market if the aggressive underwriting for CMBS loans continues. “As CMBS ‘umpires’ we are prepared to call credit quality as we see it …. If the conduit loan underwriting slippage continues on its current path, it is less likely that CMBS will become a dependable source of capital over the long run and more likely that it will become a boom-and-bust business that makes real estate even more volatile.”[12]
2.5 TakeAways. So let’s summarize the impacts of changes in Cap Rates. The take aways with respect to Cap Rate are:
(1)That Cap Rates are still widely discussed, even though purchasers of real estate have moved on to far more complex computer based models such as discounted cash flow and use many different tests to ultimately decide to acquire a real estate asset and how much they are willing to pay for it.
(2)That in a volatile Cap Rate market, the change in Cap Rate may dramatically change the sale price of an asset to such a degree that it swamps any increase or decrease in NOI from the property.
(3)That an increase in Cap Rates requires an increase in NOI or the fair market value of the asset decreases.
(4)A decrease in Cap Rates may provide a strong return on an asset even if the NOI is relatively stable.
(5)A change in Cap Rates can create a competitive advantage for an investor with different projected holding periods for the asset. In increasing Cap Rate periods a much, much longer holding period may be an advantage. Whereas in a decreasing Cap Rate period a shorter term investment horizon or property holding period may allow a potential buyer to pay more for an asset than a longer term investor. In both of these cases this assumes that the NOI would be relatively the same for each investor.
(6)Aggressive Cap Rates may not be long term indicators of value and underwriters and rating agencies may adjust for very low Cap Rates.
- Computer Modeling
3.1 Introduction Today the ubiquitous computer and spreadsheet have changed real estate modeling dramatically. They allow sophisticated models and major variations to be run and tested easily. Market data is readily obtainable and models can be revised to the point of almost driving the user to indecision because so many variations are possible. There is one axiom to remember however – the best model does not engender finding the best purchase price or the best long term outcome. He who has the best model does not have the best real estate business. Most often cleverness, execution and a bit of luck make more difference than the best models.