Cap Rates for Apartment Complexes Along the I-5 Corridor of Oregon

PART ONE: THE BASICS

Cap Rates – A Hot Topic: For apartment investors and apartment brokers, the subject of cap rates is critical right now.

Why Now: Cap rates are starting to change at a pretty good rate in  response to the current recession and changes in apartment financing interest rates.

First – Some Background Information

What does a “Cap Rate” tell you? The cap rate is one of the best indicators of investment productivity for an income producing rental property.

The Technique Name: The term “Cap Rate” is the main ingredient of the mathematical formula of “Capitalization Rate of Net Operating Income”.

How is the Cap Rate Used?

Note from Reader to Self: “Is this stuff worth learning?                                 Restated “What is in it for me, if I learn this stuff?”

Proper Answer: If you don’t learn about it and how to use it properly, then you had better hire someone like Bob Nelson, CCIM, then hang your financial well-being on his ability to “think properly for you”.

Restated: Learn what the prudent investor must know to protect and advance your own position.

While it certainly would be wise to hire “The Guru”, it would also be equally wise to understand what guides his thinking, in case he gets run over by a bus!!

CAP RATE APPLICATIONS

The cap rate has a number of very valuable uses, depending upon its user.

1. Owners: An owner could use the cap rate to determine the productivity of the various properties owned.
   1. Rule: The higher the cap rate, the more productive is the property’s capacity to generate cash flow relative to the value that the owner assigns to that property. .
   2. b. Rule: The higher the cap rate, the higher the property’s return
   3. c. Rule: Use the cap rate and the current available interest rate to forecast the potential benefit of increased yield that would result from refinancing the property today.
   4. d. Rule: When it comes to portfolio adjustment time, use the cap rate to identify the “runt of the litter” (worst performer), then exchange that one into a more productive property.

1. 2. Buyers: A buyer can use the cap rate to determine the relative appeal of several properties being considered.
   1. a. Rule: All other features considered equal, chase the property that offers the highest cap rate, and kick the low performer to the curb.
   2. b. Rule: If the indicated cap rate at the asking price is too low, then offer a lower price.
      1. i. Force the offer price to generate the cap rate that is your minimum purchasing criteria for investments of comparable risk, similar location, and similar physical characteristic.
      2. ii. This may not work for the seller, but you can make wise decisions using the cap rate selection criteria.

1. 3. Sellers: A seller can forecast with a high degree of accuracy what a reasonable asking price should be for each property that they own.
   1. a. Rule: Apply the “current” market generated cap rate to the NOI of each property to forecast how a qualified buyer would probably respond given a particular asking price.
   2. b. Rule: Use the cap rate and the current available interest rate to forecast the potential benefit of an increased yield that would result from refinancing the property today.

WHAT IS NET OPERATING INCOME?

The Net Operating Income (“NOI”) is the annual cash flow that you would receive if you own the property free and clear of debt and before paying your income taxs on the received cash flow (“cash flow before debt service and before person income taxes”).

The “NOI” Formula  –   For Apartments:

Scheduled Gross Rental Income (at current rental rates)

–   Vacancy and Credit Loss loss from vacant units and no-pay tenants

Effective Gross Rental Income

+   Other Dependable Income such as:

Tenant Deposits (while not “income”, it offsets expenses later)

Sub-metered Utility Income (if units are sub-metered)

Vending Income (laundry income, etc.)

Effective Annual Income

–     Fixed Expenses: (expenses that do not vary with occupancy)

Property Taxes

Property Insurance

–          Variable Expenses: (expenses that vary with occupancy)

Property Management

Advertising

Legal and Accounting

Utilities (provided by the owner)

Trash Removal

Maintenance and Repairs

Supplies

Grounds Maintenance

Reserve For Replacement of Short Lived Assets

Net Operating Income  “NOI”

Again, Net Operating Income “NOI” is the amount of annual cash flow that you would receive if you:

1. 1. receive all of the income that is reasonably available from a well managed property;
2. 2. own the property free and clear of debt; and,
3. 3. prior to paying income tax on incomes received from the property

If you think about it, that is a very sensible way to measure the true productivity of the property.

1. 1. The mortgage payment is not a function of property productivity.

It is a function of property ownership.

Restated: the property doesn’t come with a mortgage. I may have to put a large mortgage on the property in order to own it. While you could own the property free and clear of debt. For both of us, the property will produce the same NOI.

• A very large portion of that NOI will have to be used to service my large mortgage loan.
• You get to keep what I paid as mortgage payment as your cash flow since you have no mortgage.

What Is NOT Included In NOI?

As previously stated, the mortgage payment and your personal income taxes are not considered in the calculation of  Net Operating Income “NOI”.

There are other expenditures that would be incurred periodically, but those expenditures are not part of NOI.

Example: A Capital Improvement – those improvements that not be recurring annual expenditures that would extend the useful life of the property.

Example:  New Roof. While a new roof is necessary to protect the asset and its ability to attract and retain tenants, the cost of the new roof would not be included in the calculation of NOI.

Why: The cost of the new roof is not a recurring annual expense. You don’t pay to put a new roof on every year… unless the property is located in Tornado Ally…

CALCULATING THE CAP RATE

The mathematic relationship that calculates a “Cap Rate” is demonstrated below in a circle diagram.

Cover the component you wish to calculate, and the formula for its calculation is demonstrated by the circle diagram

NOI  =   Net Operating Income (of a comparable property)

R    =   Cap Rate (derived from the market)

IV   =   Investment Value (or Sale Price of a comparable property)

USE: To calculate Cap Rate “R”, then cover the “R” and it shows you that you take the NOI of the property and divide it by its Sale Price.

Typical and Common Cap Rates in the Pacific Northwest:

Rental Houses:                4% to 5% cap rate

Duplexes                         5% to 6% cap rate

Larger Apartments           7% to 9% varies with location and condition

R =  NOI / Value It is a market derived percentage that reflects what a specific type of highly similar properties are selling for relative to the NOI that those properties generated at time of sale

PART TWO:  BEYOND THE BASICS

Assuming that you have a reasonable understanding of Net Operating Income “NOI” and Cap Rate “R” let’s consider what such knowledge can do for an informed investor

FOR APARTMENT COMPLEXES

IN THE

PACIFIC NORTHWEST

CAP RATES HAVE INCREASED RECENTLY

Starting about mid-January, 2010, cap rates for apartment complexes have increased noticeably.

2009 to 2010:

6.5% on attractive well located apartment complexes

6.75% to 7.0% for older but well located complexes

7.0% to 7.5% for older “so-so” maintained complexes

Mid-January 2010 to present mid-March 2010:

7.0% on attractive well located apartment complexes

7.25% to 7.75% for older but well located complexes

8.0% to 8.5% for older “so-so” maintained complexes

Preliminary Market Observation: Cap Rates of mid-sized apartment complexes have risen about ½% from, early January 2010 through mid-March 2010.

WHAT CAUSES CAP RATES TO CHANGE?

1. 1. Availability of qualified buyers willing to purchase
   1. a. In my opinion, there are more cash-heavy buyers looking to purchase in mid-March 2010 than existed in September, 2010.
   2. b. I sense that cash heavy investors have been sitting on the side-lines “waiting for the bottom of the income property market” in the current recessive market.
   3. c. They are tired of receiving 1.5% on their savings accounts, and are attracted by the 8% yields that could be had on a free and clear apartment complex.

1. 2. Some fairly desperate sellers needing to sell
   1. a. I sense that there are a number of apartment complex owners that have felt the bite of the recession, and have decided that they need to sell one or more of their portfolio assets in order to develop liquidity to protect the balance of their net worth
   2. b. More desperate sellers will accept lower prices, thus causing a higher cap rate for the property that they are selling.
   3. c. As the cash heavy buyers see increasing cap rates, those rates on other competing complexes will be applied to all other properties on the open market.
   4. d. A limited feeding frenzy could develop as investors move to acquire attractively price apartment complexes with low fixed interest rates. It simply makes sense to buy now. The moon and stars are in alignment for the perfect buying season.

1. 3. Lenders that typically finance apartment complexes are become more and more conservative in their lending practices.
   1. a. They will instruct commercial appraisers to be more conservative with their appraisal reports. They will have more conservative estimated of the property’s NOI, and the “Overall Rate of Return” (effectively the “Cap Rate” used by the appraiser) will be increased with each increasing market cap rate observed in the market.
   2. b. The lender will use a more conservative Debt Coverage Ratio “DCR” when determining the amount of money that will be loaned relative to the property’s capacity to service the debt.

PROBABLY FUTURE ACTIONS

Nelsonian Wild-Eyed Philosophizing:

1. 1. Concerning Cap Rates: Cap rates for apartment complexes will increase slightly, but will stabilize until such time when interest rates increase significantly. Then, cap rates will parallel the increase in interest rates.

1. 2. Concerning Investor Greed:

1. a. Investors who get too greedy (insist on using too high of a cap rate) will be snubbed by apartment complex owners who are not desperate to sell.
2. b. Those investors who are more moderate in “throwing their purchasing weight around”  (e.g.  will accept “market rate” cap rates) will be in an excellent position to acquire the BEST ASSET TYPE WITH THE HIGHEST OVERALL PROBABILITY OF SURVIVING THE CURRENT RECESSION
3. c. Restated: The greedy will become the needy

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STAY TUNED FOR MORE EDITORIAL COMMENT,

AS I OBSERVE CHANGE IN OUR MARKET PLACE

Thank you for your attention

Bob Nelson, CCIM

Real Estate Investment Broker

“The 1031 Guru”

Pacwest Real Estate Investments, LLC

711 Country Club Road

and

3130 Beech Street

Eugene, Oregon 97405-4344

(541) 485-8100

bob@1031guru.co

www.1031guru.com