Going Rates for Real Estate
Cap rates have held despite weakening fundamentals, but how will rates be impacted in the second half of 2003 and what will that mean for shareholders?
[May/June 2003]
By Michael Fickes
Last year, Boston Properties, Inc. (NYSE: BXP) paid $1.06 billion for Citigroup Inc.'s headquarters at 399 Park Avenue in Manhattan. The price stunned some investors, especially given the tough economic climate. What made this particular building worth more than a billion dollars?
But real estate companies, including REITs, buy more than just buildings; they buy capitalization rates or yields, just like bond investors buy interest rate yields.
The capitalization rate (cap rate) on a real estate investment expresses the relationship between various operating performance measures such as net operating income (NOI) and the price or value of the property. In evaluating these numbers, companies and shareholders use various formulas.
Unlike bond yields, however, cap rates on individual properties often remain confidential. For large transactions like 399 Park Avenue, company shareholders and analysts are often left to guess at the yield. They do this by dividing their best estimate of annual NOI by the price paid for the building. The street analysis of the yield at 399 Park Avenue suggested a return of 7.8 percent.
Another way of looking at real estate property transactions is to multiply the cap rate or yield by the purchase price to determine NOI. In the case of 399 Park Avenue, 7.8 percent times $1.06 billion equals NOI of $82.7 million a year.
Such calculations illustrate how real estate companies, shareholders and analysts compare one property investment with another. Just as investors compare yields on stock dividends or bond interest rates when evaluating those investments, they can compare cap rate yields on potential real estate purchases.
For example, an investor might conclude that the uncertain returns from the stock and bond markets today make the 7.8 percent return on a $1 billion dollar investment in 399 Park Avenue look pretty good.
Cap rates can also be another tool shareholders use to evalute their overall investment. "Cap rates can also help shareholders monitor the performance of the REITs they own," says Robert M. White, Jr. president of Real Capital Analytics, Inc., a research firm specializing exclusively in the real estate capital markets.
White adds that a REIT should theoretically acquire properties with cap rates slightly higher than its dividend yield. "A REIT with an 8 percent dividend should theoretically acquire properties at cap rates higher than 8 percent. That means the acquisition will probably be accretive."
Shareholders must, however, account for quality in this kind of analysis, cautions White. "The better the property, the more it will cost, and the lower the cap rate will likely be," he says. "Over time, a high-quality property bought at a relatively low cap rate will likely increase its returns. Properties bought on the cheap for the sake of getting a high cap rate may not be able to sustain that performance."
Negotiating Cap Rates
So how do companies determine the cap rate for a given transaction? In the preliminary stages of a deal, buying and selling parties often make different assumptions in computing cap rates. Suppose a seller's income statement shows insurance costs of $200,000, while a buyer's analysis suggests that pending insurance premium hikes will require $250,000 per year for insurance. By adjusting NOI down by $50,000, a buyer sees lower yield in relation to the set asking price.
Buy-sell negotiations always involve discussions of bottom line income, says White. A seller might assume that an office building will be 97 percent occupied, while a buyer might evaluate remaining lease terms and decide that occupancy will end up at 95 percent. Lower occupancy means lower income and lower yield.
"Sellers want to be as aggressive as possible about income assumptions—without losing credibility," White says. "The buyer must bring those assumptions down to earth."
Negotiations usually do not incorporate the benefits a buyer might receive by leveraging a purchase. Leverage, of course, can increase returns for a buyer, but a seller only cares about
the price, continues White.
Cap rate analysis informs every stage of real estate investment. It begins when investors allocate portfolios among investment categories such as stocks, bonds, real estate and other investments. It continues through an analysis of the various categories of real estate available for investment: office, multifamily, industrial, retail and others. Finally, it forms the heart of buy-sell negotiations.
What does all this mean in the current real estate market? Real Estate Portfolio recently asked a panel of analysts and REIT executives to evaluate current cap rates in four real estate categories: industrial, multifamily, office and retail. The panel evaluated cap rate movements in 2002 and discussed how rates might change during 2003.
