You have two identical buildings - one with an above market lease and one with a below market lease. Which one do you use a higher/lower cap rate for? Explain please.
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The building with the above market lease is more valuable and therefore would use a lower cap rate.
I don't agree. You are correct that the above-market building has more value at this point in time, but 1) that lease is finite and will almost certainly return to market, and 2) you wouldn't "use a lower cap rate" in order to offer a higher valuation, the increased NOI that (presumably) results from an above-market lease would result in the higher valuation when using the same cap rate.
So in my opinion, one would use a slightly higher cap rate to value the building with an above-market lease, because that higher NOI will eventually revert to market. Alternatively, you could use adjust your NOI stream to reflect market rents/NOI and apply a market cap rate. Then add the NPV the above-market portion of the rent/NOI in order to give the seller credit for their temporary above-market lease.
+1 for me ceterus paribus
Just from an arithmetic standpoint, if you had two identical buildings in two identical markets, and both will roll to market and have the same rents next year, the building w/ the higher rents is going to have a higher NOI, so NOI/Value is going to be higher for the building w/ the above market rents than the for the one w/ below market rents, and since NOI/Value=Cap, the cap for the below market building is going to be lower.
Also, as mentioned below, below market rents are going to be more desirable because they both mitigate downside and provide a clear and tangible path to upside, whereas the bldg w/ the above market rents does the opposite.
I don't disagree with the arithmetic you laid out, but the question was "which one do you use a higher/lower cap rate for", implying that the question is related to determining a value.
If you're assuming Bldg 1 has a lower NOI and Bldg 2 has a higher NOI, but both Bldg's values are the same -- yes Bldg 1 has a lower implied cap rate. However, once a buyer has settled on a valuation, I personally would no longer refer to this equation as the building's cap rate (which is used to determine value), I would refer to it as a going-in yield (NOI/Cost).
If the Bldg 2 had NOI of 100 because of the above market rent, and you capped that at 5%, you'd pay $2,000 for it. Let's say the following year, your tenant/rent reset to market, and your new NOI is only 90. Assuming the same 5% cap rate to determine value, your building is now only worth $1,800, so when you purchased the asset, you should have used a higher cap rate knowing this scenario was likely to play out. Or, as I suggested, you project NOI using market rents, use the 5% cap rate to determine "market value" -- then add the NPV of the above market rent component.
Market NOI / Market Cap Rate $90 / 5% = $1,800; plus NPV of above market rent ($100 - $90) = +/-$10 PP = $1,810
I'd say the below market tenanted building would have a lower cap rate due to an investor being able to price in his ability to turn tenants and achieve market rents.
The first building is stabilized there is no meat on the bone for an investor.
it partly depends on the length of the term left on the leases. All things equal, you will use a lower cap rate on the above market lease. EDIT: I am wrong, MonkeyWrench below is right.
What? Don't agree with the above. An above market lease is higher risk because your income stream is finite and there's a high probability that the tenant blows out or has a fat reset/decrease once the contract term is over. Think about it. A good selling point/recurring theme on ICOM memos is that there are 'below market rents'. You never see the same said about above market rents being a positive when pitching to investment committee. There's a reason that you hear about sub 4 cap industrial deals on the west coast - it's because the rent growth is projected to be so high or there is such a big spread between in-place and market rent that you're going to get a substantial bump once it rolls.
If you buy a 5 cap and it turns into a 3 cap into the duration of your hold, you aren't ever going to make money. But if you buy a 3 cap and it resets to a 5 cap, you will make a ton of money on your exit.
I completely agree with you. While it seems a bit backwards of thinking, above market rents are going to demand a higher cap rate on in-place NOI in the capital markets, just like below market rents are going to demand a lower cap rate on in-place NOI. It has less to do with the risk of the immediate cash flow, and more to do with the re-tenanting risk and the fact that you’d likely struggle to demand above market rents again.
This is true, but for all we know the building could be leased to the U.S. government on a 99 year lease. Without knowing the credit of the tenant and the terms of the lease it's impossible to make assumptions.
But then you wouldn't be evaluating this as real estate speculation, you'd be pricing it like a bond. This isn't apples to apples, as you wouldn't be having a discussion about whether it's 'below' or 'above' market, because the 'market' piece has been taken out of it.
Can you explain this a bit more? Never thought of it like this.
Yield enhancement. Whether that is through rent growth, rolling tenants to market, etc. that is how you make money without relying on systematic cap rate compression.
If you buy a building for $10,000,000 at a 6% cap, then the NOI is $600,000. Now let’s say that everything stays the same, and the NOI moves to $800,000 by rolling tenants to market (which is a NOI yield of 8%). Market cap rates for the building your selling have decompressed to a 6.5% cap, which intrinsically means that you’re able to sell the building for $12,307,692.
I think a lot of people that aren’t acquisitions/investment sales fail to realize that cap rates are determined by the market, and reflect the price the market is willing to pay for a given cash flow stream. You can’t really change a cap rate - you can change a yield. Both are calculated the same way, but mean very different things.
There's a LOT that goes into cap rates...I'd recommend reading some academic info on it, because way too often are they understood and over simplified. On that note, you can apply a cap rate based on a comparable, and then apply your NOI. The other way to look at it, is to think of a cap rate as the yield on the property. The above market lease would result in a higher yielding asset...thus a higher cap rate.
Above market rents will receive a higher cap rate - period. It's important to keep in mind the quality and quantity of the income AND the risk/potential upside associated with said income. Above market rent is not as secure as below market rent and a higher cap rate will be applied to it.
We see this exact example all the time in the valuation world where a fully rent stabilized apartment building in Manhattan will trade at a lower cap rate than an identical building leased fully at or above market rent.
Credit of the tenants, remaining lease term and options are items to consider.
I stopped reading but seriously... everyone here... who is actually a cap rate buyer? Cap rates are so cursory (in bitchy white girl voice).
In my exp most are IRR buyers Those that are not are cash on cash buyers
the above mkt rent would really just be an investment consideration is reflected in overall pricing.
maybe im being sophomoric..
This doesn't make a lot of sense. Aside from purchase price, which input is the IRR output most sensitive to?
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