Basis for Cap rate?
Hi Forum,
I am going to prepare for a modeling test for a senior analyst real estate investment position and have 2 questions:
First question:
When I make a couple of models for training purposes, I always used the formula for calculating the purchase price: NOI year 1 / Cap rate = Purchase price year 0
I am aware that one should use a stabilized NOI. But what do you do when you know that the building is not stable at the moment (e.g. 20% vacancy)? Should you come up with a stabilized NOI based on 100% occupancy and rented at market levels?
Second question:
What generic assumptions do you generally use when doing such a interview modeling test? E.g. for transaction costs, taxes etc?
If not given by the model, how many cost items would you include? E.g. only non-recoverables to get to NOI, or would you assume Tenant Improvements, Lease Commissions, different non-recs, AM fees etc.?
And finally, out of your experience, (i) how "difficult" do you think will be the debt part? E.g. only senior loan, or several tranches, mezz, PIK etc? And (ii) what different return metrics would you show? So far I always only included IRR and a cash-on-cash multiple.
Your feedback is much appreciated! :)
Many thanks.
1) In the case this is new construction then you'd lease up to market occupancy so 95%ish.
2) Transaction costs ~ 2%,
Sounds like you've made it past the first round or two, so congrats! As to your questions:
1) If you're given no background information on the asset/market for which you'll be making the model, then I would assume a 5% vacancy factor on your stabilized NOI. Hopefully you'll be given information on what asset type you're modeling and where it is located, which will allow you to make a more informed decision on what rent levels you'll be grossing up and what a more likely stabilized vacancy factor to use.
However, this might all be a moot point since the purpose of the exercise is for you to setup a model, which should include the ability for anyone to change a few of your assumptions (rents, vacancy, transactions costs as a % of the sales price, cap rate, etc.) and the remaining calculations would automatically incorporate these changes without the need for any hard coding.
2) Transaction costs vary depending on location, taxes, etc. Typical assumptions range from 1% - 4%.
3) (i) The debt component is typically the easiest part. Equity component can be more involved depending upon your interviewer's desire for waterfalls. Even adding a mezz component to the debt is fairly simple, and they will likely ask you to calculate an all-in coupon (weighted average of senior and any mezz component, a simple calculation using the sumproduct function) which should be fairly easy and straightforward.
3) (ii) If you're asking about the metrics to show for the debt component, include debt yield for NOI and NCF (NOI/Debt Amount, NCF/Debt Amount), debt service coverage ratio, and mortgage constant,
If the property is not stabilized, you will want to take out the cost of downtime, leasing costs and tenant improvements below-line. You might also take out the cost to cure any deferred maintenance below-line. If all of these below-line costs add substantially more risk, and/or if the market is soft, you may wish to make an additional deduction for entrepreneurial profit below-line, perhaps around 5% of the stabilized value. If you don't have a good handle on these below-line costs, you would obviously want to use a higher going-in cap rate.
1) It really depends on the property and the case. If you have future cash flows, then just use the annual NOI where occupancy is >=95% and where free rent burns off. If you only have the unstabilized NOI and it's a new property, just gross it up to 95% occupied. If it's not a new property and said to be leased below market, then just take 95% of the property's SF and multiply it by the blended market rate. Those would be good places to start.
EDIT: you should probably do the above for revenue only and not NOI on the whole...i say this BC opex might be a different story (since opex of a 20% leased property will be different than the opex of a 95% leased property). May want to take CAM and gross that up, and leave all other line items the same. Using the new rev and opex figures, you can figure out your NOI. But again this is only if you don't have future cash flows available.
2) Wouldn't worry about AM or ACQ fees unless you are asked for pre/post fee IRRs and multiples. Always safe to assume DD costs and debt points on your equity, and sales cost on your sales proceeds. Common high level opex items are RE taxes, CAM, non-CAM, insurance, mgmt fee and non-recoverables. TIs, LCs, building improvements and cap reserve are common capital line items.
3) The ones that I did were always pretty straightforward...just a basic fully amortizing loan. Knowing how to model I/O for x years, then amortizing after probably wouldn't hurt. For metrics, it's good to show IRR and cash returns, but could also ask for DSCR, debt yield, current return and equity multiple. Could also ask to show CAGR on NOI as well. That's all I can think of.
Many thanks for your responses - much appreciated!
Just one more thought regarding the NOI/Cap rate:
For calculating the market value the "stabilized NOI/Cap rate = market value" approach would be correct. However, when calculating the purchase price wouldn't we take "actual NOI/Cap rate = purchase price"?
My logic behind that is, whenever I am a buyer of a 20% vacant building, I am not going to pay the market value (based on a stabilized/fully rented NOI) but would deduct something in order to address the risk of renting up the space!?
In terms of modeling would it then be correct to just use the actual NOI to come up with a reasonable purchase price?
Please excuse if some of the questions might seem way to easy. I come from a senior lender where you usually think more of "can he service our debt" and where you are provided with market values and purchase prices.
Many thanks! :)
The best thing to do here would be say some thing like "Yr 1 Cap Rate (unstabilized) = X" and "Yr 3 Cap Rate (stabilized) = Z". Also, do the same thing with value / SF (purchase price and then stabilized value)........Just as an FYI the "market value" = "purchase price" assuming it was a widely marketed deal.
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