Almost identical Real Estate but different Cap Rate
I am preparing for a first-round real estate interview and my friend said she was asked to explain why two buildings that were essentially identical, being next to each other, equally old, same costs to renovate, same property type, same square feet, but different cap rates, when she was interviewing for the same boutique last year. How can that be?
I found that one reason could be different tenant structure, but I cannot really think of other reasons. Perhaps the tenant's solvency and the occupancy rate of the building?
What would you answer and are my thoughts correct or not?
Your answer is good. There are a lot of possibilities for this.
Another could be that one of the sellers or buyers of the the two buildings are simply more conservative or aggressive than the other. Cap rates aren't static, you know? If building A gets bought for $50MM and building B gets bought for $55MM, for whatever reason, the cap rates are going to vary.
Your thinking is in the right direction, the question is seeing if you understand the role leasing and tenancy plays in valuation. Short answer, it's huge, easily overpowers most physical attributes and even locational attributes. Of course property quality/location sets the rents and types of tenants that a building can get, but it's still the actual leases that really sets the value an investor will pay.
Correct - tenancy is a proxy for the quality of the cash flows. For example, if one building had a single credit tenant with 10 years left on the lease, it would likely trade for a lower cap rate than the same building occupied by a “mom and pop” tenant with a month to month lease.
Different tenants / lease structures / occupancy, Different debt (one free and clear and one not), different tax jurisdictions if they straddle a border, different operating expenses, one building is on a ground lease
A building with 20 different tenants, half of which are on a month to month status is going to be way riskier and demand a premium yield (cap rate) to a building 100% occupied by a handful of blue-chip tenants demonstrating a weighted average lease term of 7 years.
Think about it this way:
Two identical buildings, same construction, same finish level, same everything:
Building A: 100% Leased to Walgreen's...50 year NNN lease, no landlord responsibilities.
Building B: 50% leased to Johnson Pharmacy, 2 year gross lease, no extensions, no rent bumps. 50% leased to Smith Pharmacy, month to month lease.
Both generate the same NOI--one is a much stronger building that would be more compelling to most (all) buyers. The rent roll of your asset, coupled with the credit-worthiness of your tenant, will dictate the overall assumed riskiness of the asset, and thereby dictate your cap rate.
All the answers about tenancy are probably technically correct, and what the interviewer is looking for.
But I'd argue an equally valid answer is the Seller. A closed-end fund coming up on the end of it's life might have more pressure to sell than a long time owner-occupant who will only deal if you blow their socks off with an offer. Or the reverse - perhaps this single asset represents most of a seller's net worth and they need to move it for reasons unrelated to the building itself. All of those and a million other permutations could be a reason to price a building higher or lower. Maybe they're subject to different regulations (for example in NYC, maybe one is in the AEP and the other isn't, or one needs a CONH and the other doesn't).
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