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Principles of Hospitality Real Estate

Capitalization Rate

Peng Liu [email protected]

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Principles of Hospitality Real Estate

Learning objectives § At the end of this session, you will be able to § Estimate cap rate § Discuss cap rates across various property types § Valuate commercial real estate using income capitalization approach

§ Reading: Linneman and Kirsch Ch9. The Use and Selection of Cap Rate

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Basic cap rate valuation § Capitalization rate (Cap) 𝐶𝑎𝑝! =

𝑁𝑂𝐼" 𝑉!

§ When valuating a real estate at a particular year, we use next year’s NOI.

§ Real estate asset market equilibrium measure § Income multiple analysis § Income capitalization approach § Historic linkage to bond market

Capitalization Rate, Income Multiple and Valuation Equations Cap Rate = Stabilized NOI / Value = 1 / Multiple Multiple = Value / Stabilized NOI = 1 / Cap Rate Value = Multiple * Stabilized NOI = Stabilized NOI / Cap Rate Example: an "8 cap" = .08 = 8.00% = 12.5x Multiple

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Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Recall: Felicitas tower valuation Think-Pair-Share discussion § Suppose you are faced with the opportunity to be a stakeholder in the acquisition of an office building, Felicitas Tower, leased to the U.S. government for 10 years. Based on your analysis, you estimated that net cash flow will be about $3 million each year for the lease. § How do you assess what the Felicitas Tower is worth? § Hint1: Use DCF! what is the net cash flow? What is the discount rate? § Hint2: What assumptions you’ve used? § Hint3: Utilize a risk and opportunity framework relative to other investments in addressing this question.

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Felicitas tower valuation example Felicitas Tower Cap Rate and Multiple Valuation Assumptions Yield on 10-Year T Note Risk Premium Cap Rate Multiple NOI

3.60% 100 basis points (bp) 3.60% + 100 bp = 4.60% 1 / .046 = 21.7x $3 MM

Valuation With Cap Rate With Multiple

$3 MM / .046 = $65.2 MM $3 MM * 21.7 = $65.2 MM

Cap Rate Spectrum and Equivalent Income Multiple Spectrum Relatively high cap rate; Less expensive per dollar of NOI

Relatively low cap rate; More expensive per dollar of NOI Capitalization Rate

…

10.0%

9.5%

9.0%

8.5%

8.0%

7.5%

7.0%

6.5%

6.0%

5.5%

5.0%

4.5%

4.0% …

16.67x

18.18x

20.00x

22.22x

25.00x …

Equivalent Income Multiple … 10.00x 180

10.53x

11.11x

11.76x

12.50x

13.33x

14.29x

15.38x

Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Not everyone agrees § In a recent real estate transaction, the buyer paid $65 million for the building, he says he bought it for a 5.6 cap. However, the seller of the building who received the $65 million, might brag that he sold it for 4.6 cap. § How is this possible?

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Cap rate definition recap § Cap rate definition recap: 𝐶𝑎𝑝! =

𝑁𝑂𝐼" 𝑉!

§ Assumption: stabilized property with stabilized NOI § A property at full occupancy, except for an expected “systemic” level of vacancy, whose NOI is flat or growing relatively smoothly year-over-year. § For instance, a 100-unit apartment building with 4% yearly vacancy and 2.5% yearly NOI growth.

§ DCF versus Cap rate § Cap rate valuation approach is simpler than a multi-year DCF model § If property’s expected NOI stream is complex with irregular rental growth driving potentially high volatility, only DCF can yield a credible value estimate.

§ Going-out cap is normally higher than going-in cap § Going-in cap rate = purchase cap rate § Going-out cap rate = exit cap rate = terminal cap rate 182

Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Gordon model – simple cap rate estimation § Gordon growth formula and cap rate valuation Gordon Growth Model for Property Valuation * Value = NOI / (property discount rate – NOI growth rate) = NOI / Cap Rate Value = NOI / (r – g) = NOI / Cap Rate Therefore: Cap Rate = (r – g) *Assumes Stabilized NOI and constant NOI growth rate for perpetuity.

§ Cap = r - g § That is Cap Rate = Discount Rate – Growth Rate § Where: discount Rate = risk free Rate + risk premium § Two types of Risk Premium § Operational risk premium associated with unexpected outcomes in the property’s NOI § Illiquidity risk premium

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Felicitas tower valuation with cap rate Gordon Model Cap Rate and Multiple Calculation for Felicitas Tower Property Discount Rate (r) NOI Growth Rate (g) Cap Rate Calculation (r – g)

4.60% 1.00% .046 – .01 = .036 = 3.60%

Multiple Calculation

1 / (.046 – .01) = 27.8x

Felicitas Tower Gordon Model Income Multiple Valuation With and Without Growth

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Discount Rate Growth Rate Multiple with growth Multiple without growth

5.60% 1.00% 1 / (r – g) = 1 / (.056 – .01) = 21.7x 1 / r = 1 / .056 = 17.9x

Valuation NOI this year NOI next year Value with growth Value without growth

$3.00 MM $3.00 MM * 1.01 = $3.03 MM $3.03 MM * 21.7 = $65.8 MM $3.00 MM * 17.9 = $53.7 MM

Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Three major determinants of cap rates 1. Risk-free Rate § Opportunity cost of capital § Higher real interest rates or higher expected returns in other types of investments will require higher expected returns in real estate, and therefore higher cap rates, other things being equal.

2. Risk Premium § How risky is an investment in this property, and how much do investors care about that risk?… § Greater risk, and greater sensitivity to risk, will require higher cap rates (lower asset values per $ of current income). § Two major risk premium associated with real estate § Operational risk § Illiquidity risk

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Market change Risk premium spread over Treasury yields

Basis Points

REIT Implied Cap Rate Spread over 10-Year Treasury

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800 700 600 500 400 300 200 100 0

Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Three major determinants of cap rates (continued) 3. Growth Rate § How much can investors expect that this property’s net cash flow (rents minus expenses) will be able to grow over the coming years?… § Higher (realistic) growth expectations will allow a lower cap rate, as investors will be willing to pay more $ today for a given amount of current net income, in order to own the property (since this income is expected to grow).

§ In summary, we again get the Gordon Growth Formula Cap rate = Risk free rate + Risk premium – Growth rate

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Concept check Two real estate stabilized properties have the same first year NOI. Other things being equal, which would have the lower cap rate, property “A”, or “B”? 1. 2. 3. 4. 5.

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A: An apartment building in a declining neighborhood. B: An apartment building in a growing neighborhood. A: An office building with full of long-term tenants. B: An office building full of short-term tenants. A: Real estate when LT bonds yield 6% (with 3% inflation). B: Real estate when LT bonds yield 8% (with 3% inflation). A: A surface parking lot in a growing downtown. B: A 10-story parking garage in a growing downtown. A: An office building with short-term below-market leases in a growing rental market. B: An office building with short-term above-market leases in a declining rental market.

Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Where to get cap rates? § Estimate cap rate using discount rate and expected growth rate from NOI § Survey results: § CBRE https://mapping.cbre.com/maps/caprate/app/ § RealtyRates.com: www.realtyrates.com § CoStar (www.costar.com) § Real Capital Analytics http://www.rcanalytics.com/ § Other appraisers and market participants

§ Market Cap Rate Extraction from comparable sales

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Market cap rate NCREIF NCREIF Cap Rates (18-month lag, last value = 2018 Q1) 16 14

Apartment Office 10-yr Treasury

Industrial Retail

Percent

12

10 8 6 4 2

0

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Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Market cap rate CBRE

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Market cap rate CoStar

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Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Market cap rate Real capital analytics

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Peng Liu, Cornell SC Johnson College of Business

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Principles of Hospitality Real Estate

Cap rate by property type Typical U.S. Market Capitalization Rate Ranges as of Early 2018 Relatively high cap rate; Less expensive per dollar of NOI

…

12.0%

11.5%

11.0%

10.5%

10.0%

…

8.33x

8.70x

9.09x

9.52x

10.00x

Relatively low cap rate; More expensive per dollar of NOI Capitalization Rate Spectrum 8.5% 8.0% 7.5%

9.5%

9.0%

10.53x

11.11x

7.0%

6.5%

6.0%

5.5%

5.0%

4.5%

4.0% …

Equivalent Income Multiple 11.76x

12.50x

13.33x

14.29x

15.38x

16.67x

18.18x

10.0%

5.0% Hotels

11.0%

10.0% C-quality shopping centers 9.0%

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22.22x

25.00x

… Notes 1

7.0% Poorly-located warehouse

15.0%

20.00x

2

6.5% 5.0% "100% location" warehouse 3 7.5% 6.0% 4 B-quality shopping centers 5 6.5% 5.0% 6 A-quality shopping centers 6.5% 7 C-quality garden apartments 7.0% 5.5% 8 B-quality garden apartments 6.0% 4.5% 9 A-quality garden apartments 8.0% 5.5% 10 1st-tier city suburban office 8.5% 6.5% 6.0% 4.0% 2nd-tier city suburban office Prime location urban apartments 11;9 6.0% 4.0% Downtown office 12

Peng Liu, Cornell SC Johnson College of Business

Principles of Hospitality Real Estate

Closing thoughts § Real estate valuation tends to have tighter bids § Contractual information § Responding to the market - infrequent need for valuation

§ Cash flow cap rate § Use adjusted NOI, which is unlevered cash flow after reserves

§ Execution is key in real estate § Achieving the goal set up in the pro forma projection § Skills and experience

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Peng Liu, Cornell SC Johnson College of Business

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