When you're applying an exit cap rate are you capping NOI before or after replacement reserves are subtracted? I've seen it both ways recently, so was curious how others looked at it.
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I do apartment development deals. We assume little or no replacement reserves since we are dealing with brand new buildings, and so we cap noi before reserves are subtracted.
I can definitely see the argument for including reserves for value add/older buildings deals though.
It depends on if you're a broker or a buyer.
Generally, when people are talking about cap rates, they mean before reserves NOI. Although cap rate post reserve noi is a good metric to keep in mind.
We do NOI before, when you remove reserves that figure in my opinion is no longer NOI, but unleveraged cash flow.
How is your cap rate being calculated? That is how you should cap income. If you take a no reserves cap rate and use it on with reserves income, you’re understating your exit value, if you take a cap rate derived for income with reserves and stick it on income without reserves, you are inflating your value by combining a lower cap rate and higher noi.
After for multi family. Before for all other commercial. Same as direct cap. Coming from a conservative LP investment shop.
friggin' conservative lps ruining all the fun for the cowboys shooting from the hip.
tell'em to go back to harvard
Say that now but you’ll be kissing my feet and taking me to Morton’s when you need my $30mm equity check for your shit development. Haha
I always cap NOI with reserves included. The question isn’t what is real or what is accurate or am I lowering my valuation. The question is what will the buyer do? And the buyer will always underwrite reserves.
Agree with this. It's how I always valued deals when I was on the LP/acquisitions side. The point of the reserve is to account for normal wear and tear that happens throughout the normal course of operations. If you don't want to underwrite it on CF, then underwrite an upfront reserve instead, but its an expense that will be incurred so it should be accounted for.
Bank here and above the line.
Most brokers/buyers/lenders I know cap NOI after reserves are removed as it is a real expense. Caps are somewhat worthless anyway since no one buys all cash and the true capitalized stuff is on the balance sheet and off the P&L. The true test should be actual cash flow after debt/fees/capital/etc since that's all that matters, how much cash am I generating on my cash invested.
Technically speaking, from an ownership and GAAP perspective, capital reserves are capital expenses, are not an operating expense and thus go below the line or after NOI. You also cannot reimburse for capital reserves. But, just because they aren't included in NOI doesn't mean they aren't important or need to be accounted for.
If you are a prospective buyer and coming up short on an offer because you're capping NOI after deducting replacement reserves then you would just have to take them out below the line to hit the number as that's what the other buyers will do.
Regardless, any lender will take replacement reserves above the line effectively as a stress test to your NOI and if they were previously looking at 65% LTV with replacement reserves above the line, well now they are at 64% LTV on your numbers because they underwrote reserves above the line.
In short, it all comes out in the wash because it's still an expense that can't be ignored and whether it's operating or not doesn't really matter at the end of the day.
This is the answer right here. Going off of of your third paragraph related to loans, lenders will oftentimes include a replacement escrow/reserve in your loan that you draw for while the work is performed rather than immediately giving you the funds. This is done to prevent the misuse of funds and ensure the work is completed.
another thing to keep in mind is adjusting for your taxes at reversion
Include reserves.
As you can see from some of these answers, there is no good answer. Some conservative underwriters want them included, some don't. We include them above the line, and that is for new development deals. No right answer here.
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