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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   May 2009

Cap Rates: That's a Wrap?

Increasingly, investors are using internal rate of return -- not cap rates -- to measure potential

With increasing capitalization rates and tightening capital, real estate values are declining each day.c_2009-05_Clauson_spot

From 2002 to '08, if a property-owner maintained a level net operating income (NOI), the asset's value would appreciate daily without any other effort because of declining cap rates. This made ownership attractive, albeit creating an appreciation-focused mentality.

Today, the reverse is true. As capitalization rates increase, the asset's value is depreciating daily. This requires real estate investors to seek an alternative or secondary method that is more comprehensive to calculate an asset's value. Many are turning to the internal rate of return (IRR).

Why IRR?

Until recently, lenders viewed real estate investments as stable. Those same lenders, however, now are having trouble ignoring the perceived risks. Thus, they want more equity to secure loans and more-stringent underwriting.

Lenders now evaluate the asset's fundamentals closely, and this is changing the way mortgage professionals must work.

In the past, IRR was considered an awkward method for determining an investment's yield, in part because it did not account for the cost of capital when computing negative cash flows, as well as because of its deficiency in comparing like investments with varying holding periods. It is gaining wider acceptance, however, and often has supplanted cap rates as the most reliable indicator of real estate investment potential.

In fact, when the market overheated and came to a near-standstill in 2008, IRRs began to replace cap rates as the more-popular method for ascertaining a property's value. In today's market, therefore, mortgage professionals must engage their skills to meet the demand of their clients to use this tool.

Cap rates vs. IRRs

A cap rate is a measure of the ratio between the NOI produced by an asset -- usually real estate -- and its capital cost (i.e., the original purchase price) or its current market value.

There are a several shortcomings of the cap-rate-evaluation process, including:

  • Failure to address the structuring of debt or appreciation;
  • Tax implications; and
  • Reversionary proceeds -- the cap rate only recognizes the annual cash flow a property produces, not the change in its value.

Accounting for the debt structure is essential when projecting the total anticipated yield. If all of the acquisition's elements were identical with the exception of interest, the investor's total return significantly improves not only with more-favorable financing terms. Cap rates, however, fail to calculate this difference, which reveals an essential shortcoming.

Appreciation also is not a part of the cap-rate process. Not all property types or locations appreciate at the same levels. By their nature, cap rates also are not intended to analyze these components.

IRRs, however, account for these factors based on information the mortgage or real estate professional provides.

Real estate investors are increasingly using the IRR to help guide their investment decisions. It represents the total return on an investment, including annual cash flow and residual proceeds at the end of the holding period.

Stated another way, an investment's IRR is the discount rate that makes the net present value of its income stream equal zero.

Because IRR standards are specific to each individual investor and include more statistical elements, many investors now consider IRRs a more-reliable methodology.

A project is considered a good investment if its IRR is greater than the rate of return that someone could earn from alternate investments of equal risk (e.g., investing in other projects, buying bonds, etc.). Thus, a mortgage professional must determine the IRR not only of a specific asset but also of comparable assets -- as well as other investment vehicles and clients' risk tolerance.

Another reason the IRR is becoming more popular is that its calculation includes the assets' sale proceeds and the flexibility to calculate before- or after-tax rate. When looking at commercial real estate, investors apply the desired discount rate to an asset based on their individual aspirations and risk-avoidance parameters using the IRR calculation.

Therefore, the IRR likely can portray a more accurate, comprehensive evaluation of the asset's value than cap rates can.

•  •  •

Investors and lenders traditionally have used the cap rate to determine real estate's underlying value based on their individual criteria. In the past, as capital was chasing deals, in part because of relaxed underwriting standards that made more funds available for the real estate asset class, increasing levels of funds entered the real estate market, competing for a limited amount of inventory. This resulted in downward pressure on cap rates.

We are now in a correction period, which is just as radical as the overheating. This correction period is bringing with it a rethinking of an asset relative to value.

Investors today are looking at real estate as mostly about cash flow, less about appreciation growth and still as an inflation-hedging strategy.

To adopt these foregoing elements into an informed decision, cap rates are inadequate. Although the IRR calculation is not a silver bullet, it entails more of the essential means required to determine a property's underlying value in a changing market.


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