Capitalization Rate Sensitivity Chart PDF

DIMENSION 5 - 54 CAPITALIZATION RATE SENSITIVITY CHART NOI ÷ Cap rate Value $1,000M $1,000M $1,000M $1,000M $1,000M 9.5% 9.75% 10% 10.25% 10.5% $10,526M $10,256M $10,000M $9,756M $9,523M DERIVING THE CAPITALIZATION RATE There is quite a science behind determination of capitalization rates and, unfor...

DIMENSION 5 - 54 CAPITALIZATION RATE SENSITIVITY CHART NOI ÷ Cap rate Value $1,000M $1,000M $1,000M $1,000M $1,000M 9.5% 9.75% 10% 10.25% 10.5% $10,526M $10,256M $10,000M $9,756M $9,523M DERIVING THE CAPITALIZATION RATE There is quite a science behind determination of capitalization rates and, unfortunately, rules-of-thumb are not generally accurate. Professional appraisers receive a great deal of training in this area and must consider many factors in arriving at this powerful variable. This gives rise to two basic approaches to formulating the cap rate. One is theoretical, and the other approach is practical. THE THEORETICAL DERIVATION Theoretically, cap rates are derived from application of the band of investment technique. The basic premise of the theory is that an investor’s target return will be a function of the weighted average cost of capital. For example, if an investor seeks a 10% return on equity on an investment that will be 30% equity funded and 70% debt funded at 8.25%, the weighted average cost of capital is 8.775%, as shown: PERCENTAGE OF COST FUNDED BY: Equity 30% Debt 70% CRC US Body of Knowledge Weighted Average RETURN 10% 8.25% (interest) WEIGHTED AVERAGE 3.0% 5.775% 8.775% When applied to cap rates, this weighted average calculation will include not only the direct borrowing cost (interest, or return on capital) but also the return of capital to the lender (the debt amortization). The calculation of the cap rate will, therefore, use a loan constant rather than an interest rate. Here’s an example: Assume a real estate investment property will be funded with 70% debt and 30% equity as shown prior. Assume further that: The loan will bear interest at a rate of 8.25% and have a 20-year amortization, making the loan constant 10.22% The investor’s expected cash on cash return is 8% The overall capitalization rate is calculated by weighting the cost of the debt and equity components of the financing and adding them together as shown here: DIMENSION 5 - 55 Adjusting the prior calculation for a loan constant of 10.22% (reflecting an 8.25% interest rate and a 20-year amortization) would result in a cap rate of 10.15% as follows. PERCENTAGE OF COST FUNDED BY: 30% Debt 70% WEIGHTED AVERAGE 10% 3.0% 10.22% (Constant) Weighted Average 7.15 % 10.15% The overall cap rate is often rounded to the nearest tenth, or in this case 10.2%. BAND OF INVESTMENT APPROACH WEIGHTED COST OF CAPITAL CONCEPT Investment Proportion Yield Required Weighted Average Equity 25% 15% 3.75% Debt 75% 8% 6.00% 100% 9.75% THE PRACTICAL DERIVATION Because information regarding investor target risk returns and cost of capital is not widely distributed, or reliable, the more popular and practical derivation of the cap rates follows a different approach: market extraction. Market extraction is the primary method used by appraisers to determine capitalization rates. Using market extraction, the appraiser examines the overall rates of return (often called OAR) implied by sales of comparable income properties. The OAR is determined by dividing the net operating income of a sold property by the property’s sale price. This figure represents the pretax un-leveraged return on investment that the purchaser of the comparable property will realize. The Scenario A and B examples above illustrate this capitalization rate technique. The cap rate for the subject property is then derived by correlating the data from the comparables with the data from the property being appraised. This process is called market extraction. Although the appraiser may base the subject property’s capitalization rate substantially on the extracted OARs, other capitalization rate considerations are also included in the analysis. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Equity RETURN DIMENSION 5 - 56 NOTES: DISCOUNTED CASH FLOW ANALYSIS CONCEPT OF THE DISCOUNTED CASH FLOW ANALYSIS Discounted cash flow analysis is a method of capitalizing income property cash flow; that is, using the estimated property cash flow (NOI) to determine the value of the property by applying an expected rate of return to that cash flow stream. It is similar to and builds on or refines the analysis provided in the income capitalization approach and should provide a like valuation, albeit more precise and revealing with respect to the property’s risk profile in future periods. The income capitalization approach calculates the value of an income property based on current rental rates, vacancy factors, and expenses. The discounted cash flow analysis (DCF) capitalizes the expected cash flow profile of the property for the expected holding period of the owner of the property. It then discounts the future property cash flows and the estimated proceeds from an assumed future sale of the property at the end of the holding period, to arrive at an estimate of the present value of this cash flow stream (i.e., the value as determined by the DCF analysis). THE PROCESS FOR THE DISCOUNTED CASH FLOW ANALYSIS The DCF calculates the net operating income for each year of the analysis and based on the discount rate selected, calculates and sums the net present value of each year’s cash flow. The discounted present value of the property’s expected selling price at the end of the holding period, minus expected sales commissions and expenses, is added to this value. CRC US Body of Knowledge The appraiser executes five basic steps in completing the discounted cash flow analysis. They are outlined here and illustrated in the discounted cash flow example. Estimate the net operating income (NOI) for each year in an assumed holding period giving specific consideration to existing lease terms and re-leasing expenses such as rent loss, tenant improvements, and leasing commissions. This period is typically 5 to 10 years. Calculate the present value of the annual cash flows for the holding period at an estimated discount rate. Calculate the reversion value of the property using an assumed capitalization rate. The reversion value is the estimated value of the property at the end of the holding period. The analysis assumes a hypothetical sale of the property at that time. DIMENSION 5 - 57 Deduct estimated disposition cost to calculate net reversion cash flow at the end of the holding period. NOTES: Note: The DCF is a complex set of calculations normally executed on a spreadsheet program. There are several packaged programs available to the real estate industry from various software vendors. Most DCF programs can calculate a range of values based on a range of discount rates as well as differing cap rates. The chart below illustrates the varied valuation results produced by even subtle changes in these two key variables. BENEFITS OF USING DISCOUNTED CASH FLOW ANALYSIS DCF directly factors in varied inflation rates. In a DCF, for each year of the analysis, an inflation factor is applied to rental rates and operating expenses. This is important in situations where the rental rates and expenses are not expected to increase at the same pace. For example, if expenses are expected to increase faster than rental rates, an inflation rate of 2% might be assigned to rents and a 4% inflation rate assigned to expenses. This flexibility is also important in situations where rents are expected to remain flat for, say, two years before resuming an upward trajectory. If inflation rates for rent and expenses are expected to increase at roughly the same pace, the value range calculated by the DCF approach is normally similar to the value derived from the income capitalization approach, when calculated in a direct fashion. However, DCF analysis will give a more realistic value of the property if a discrepancy or irregular pattern is expected. DCF directly factors in tenant rollover expenses. The DCF allows expenses related to tenant turnover (such as leasing commissions, tenant improvement, or refurbishment expenses) to be assigned to the specific year or years in which they are expected to occur. In the direct capitalization method, an overall average tenant turnover expense is calculated. If these expenses are expected to be significant or are anticipated to occur at several different intervals in the life of the property, the DCF will provide a more accurate valuation and endow the lender with valuable risk focused information, which can be used in structuring the loan. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Calculate the present value of the reversion cash flow at an assumed discount rate and add that present value to the present value of the cash flow stream during the holding period to get the discounted cash flow value. DIMENSION 5 - 58 NOTES: DCF captures longer-term variances in lease economics. If a lease reflects over- or under- market terms later in the lease period, these benefits or concessions can be lost in a direct capitalization approach. For example, in a seven-year lease assume the rent reduces to zero during the last three months of the lease. A DCF approach would appropriately and precisely factor in this future rent reduction. TIPS FOR REVIEWING THE DISCOUNTED CASH FLOW ANALYSIS STEP ONE: Because the DCF analysis is based on income capitalization concepts, all review tips for that valuation approach apply. If that analysis is provided separately, you should first determine that the assumptions and support provided in that analysis are reasonable and consistent. Tips for reviewing the income capitalization approach are: Carefully review the description and location of each comparable property to determine if it is truly comparable to the subject property. Focus on the timing of each comparable and verify that older transactions have been appropriately discounted in the weighting for that factor. Examine each adjustment to see that they are reasonable, well supported and consistent. The rents and vacancy rates selected by the appraiser should be well supported by market evidence, and existing or anticipated operating expenses of the building should be compared with those of similar properties and/or to general industry expense figures. CRC US Body of Knowledge Review the assumptions used in assigning the capitalization rate. DIMENSION 5 - 59 Determine if the appraiser has fully discussed and supported the additional variables and assumptions, such as inflation rates and discount rates, used in the DCF calculation. These assumptions should be well supported and the source of the data used in making these assumptions should be fully disclosed. Several national and regional data sources regularly compile information about discount rates, expense rates, etc., that institutional investors and underwriters use for various property types. A knowledgeable appraiser or broker in the local market area can suggest the appropriate sources and help lenders obtain them. DISCOUNTED CASH FLOW EXAMPLE The following is an example of a DCF valuation for a simple apartment property. Note: this illustration can also be solved on a financial calculator, although answers may vary because of rounding. Assume: A five-year holding period for an income property. Annual NOI of $1,102M in the first year. NOI increases by 3% per year. Reversionary capitalization rate is 9%. Discount rate is 12%. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral STEP TWO: DIMENSION 5 - 60 Step 1: Estimate the net operating income (NOI) for each year in the assumed holding period, giving specific consideration to existing lease terms and re-leasing expenses such as rent loss, tenant improvements, and leasing commissions. In this case an apartment property is showcased, so the re-tenanting and leasing costs are smoothed. In a multi-tenanted retail or office property this would likely not be the case. YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 $1,818 $1,873 $1,929 $1,987 $2,046 -$91 -$94 -$96 -$99 -$102 $1,727 $1,779 $1,832 $1,887 $1,944 $39 $40 $41 $43 $44 $1,766 $1,819 $1,874 $1,930 $1,988 -182 -187 -193 -199 -205 -23 -24 -24 -25 -26 -109 -112 -116 -119 -123 G&A -88 -91 -93 -96 -99 Mgmt. fees -54 -56 -57 -59 -61 Salaries -71 -73 -75 -78 -80 Advertising -15 -15 -16 -16 -17 -101 -104 -107 -110 -114 -21 -22 -22 -23 -24 -$664 -$684 -$704 -$726 -$747 $1,102 $1,135 $1,169 $1,204 $1,240 Base rents Vacancy (5%) Adjusted gross income Misc. income (laundry) Effective gross income Less expenses Taxes Insurance Utilities Maintenance and repairs CRC US Body of Knowledge Reserves Total expenses Net operating income DIMENSION 5 - 61 Step 2: Calculate the present value of the annual cash flows for the holding period at an estimated discount rate. NOTES: YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 $1,102 Discount rate Present value of NOIs $1,135 $1,169 $1,204 $1,240 12% $4,299 Step 3: Calculate the reversion value of the property using an assumed capitalization rate. The reversion value is the estimated value of property at the end of the holding period. The analysis assumes a hypothetical sale of the property at that time. NOI year 5 Capitalization rate Reversion value $1,240M 9% $13,782M Step 4: Deduct estimated disposition cost to calculate net reversion cash flow at the end of the holding period. Reversion value $13,782m Disposition cost $413m Reversion cash flow $13,369M Step 5: Calculate the present value of the reversion at an assumed discount rate and add that present value to the present value of the cash flow stream during the holding period to get the discounted cash flow value. Present value of reversion cash flow $7,934m Present value of annual cash flow Discounted cash flow value $4,299m $12,233m Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral NOI DIMENSION 5 - 62 NOTES: FINAL RECONCILIATION OF VALUE The final reconciliation of value is the appraiser’s overall assessment of value, taking into consideration findings from each analytical technique used during the appraisal process. Most commercial properties are appraised using three separate approaches to value. 1. Cost 2. Sales comparison or market. 3. Income capitalization. The appraiser must weigh the values calculated from each approach and correlate a final value for the property. WEIGHTING THE VALUES The values derived from each approach may differ significantly. However, while the temptation may be to merely average the values from the three approaches, the standards of appraisal practice require that a professional appraiser use his or her professional judgment to determine the approach or approaches to value that are most applicable to valuation of the subject property. The appraiser should list the values derived from each approach and discuss the reasoning for the choice of values having the most bearing on the final property value determined. CRC US Body of Knowledge Since each commercial property possesses its own set of unique characteristics and circumstances, there are no rules as to which value merits the most emphasis for specific types of property. However, for most income producing property, the income capitalization/cash flow approach should figure prominently in the appraiser’s correlation of final value. In an owner-occupant transaction, the sales comparison (market) approach typically carries the most weight. DIMENSION 5 - 63 REVIEWING THE FINAL RECONCILIATION OF VALUE NOTES: Appraisals should be scrutinized just as if they were a company’s financial statements. You would never make a business loan without closely reviewing a balance sheet, income statement, and cash flow statement. Appraisals should be treated no differently in the underwriting process. The arguments presented in the appraisal should be consistent and well supported. APPRAISAL REVIEW TIPS The content of an appraisal can be daunting, especially to the novice. In addition to knowing what to look for, it is useful to know where to look. These few tips are intended to expedite your preliminary review of the appraisal. Of course, you should thoroughly review the full appraisal prior to committing bank resources. Conclusions can be found at the front of the report and at the end of each section. Take the time to carefully read the conditions set forth regarding each statement of value. For example, value as is and value at stabilization are likely not the same. Consider whether sufficient funds/ resources are available to reach the value to which the loan is being underwritten. Tables efficiently display a significant amount of detail, which is also articulated in the text. Using the tables will help you focus on the specifics of the comparable properties discussed in the appraisal. Highest and Best Use section should be checked for surprises. This section usually indicates the highest and best use of the real estate is as developed or as proposed. If it does not, there is likely some economic or functional obsolescence that should be factored into the credit decision. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral When reviewing the final reconciliation of value, you should carefully examine the appraiser’s reasoning in the final correlation to determine if it is well supported and appropriate. If the appraisal has not logically led you to the same conclusion as presented, you should follow up with the appraiser to gain more insight. Alternatively, you may wish to have the appraisal reviewed by a more experienced real estate lender for another opinion on the reliability of the value estimate. For significant credits, you may want to order an independent appraisal review. DIMENSION 5 - 64 NOTES: Final Reconciliation of Value should be checked for the weighting arguments relating to the three approaches to value: cost approach, sales comparison (market) approach, and income capitalization (or cash flow) approach. Ask, “Does the reconciliation make sense?” Consistent arguments should be presented throughout the appraisal. Do not hesitate to discuss any questions you have with the appraiser. They are only human. They can and do make mistakes from time to time. In addition, note that you are responsible for articulating and defending the appraiser’s findings to your client. Your solid understanding of the appraiser’s rationale is therefore a necessity. Site Visit: Finally, there is no substitute for seeing the property with your own eyes. You, or your agent, should physically inspect the site/ property prior to, or in conjunction with, the appraisal review. If this is not possible, at a minimum you or your agent should physically inspect the site/property prior to committing the financing. APPRAISAL REVIEW FORMS The use of an appraisal review check sheet will assist and expedite your review process, and foster consistency in your focus. There are three forms provided to specifically aid you in assessing appraisal standards conformance, content, and conclusions. The forms are: 1. Commercial Administrative Review Form. 2. Commercial Appraisal Underwriting Form. CRC US Body of Knowledge 3. Business Line Residential Appraisal Review Form. DIMENSION 5 - 65 COMMERCIAL ADMINISTRATIVE REVIEW FORM Borrower Loan Officer Property Address Report Date Effective Dates Value Estimates Property Type Attach Explanation for Any “No” Responses that Affect Value Minimum Appraisal Standards (12 CFR 323.4) (a) Conforms to Uniform Standards of Professional Appraisal Practice (USPAP) (b) Written and contains sufficient information and analysis to support business decision (c) Analyzes and reports appropriate deductions and discounts for proposed construction or renovation, partially leased buildings, non-market lease terms, and tract developments with unsold units Not Applicable [ ] (d) Based on definition of market value in 12 CFR 323.2 (f ) and bank instructions (e) Performed by state licensed or certified appraiser as required USPAP Reporting Requirements (Standards Rule 2-2) Report Type: Self-Contained [ ] Summary [ ] Consistent with Bank Retention Letter: Key Words: Self-Contained = Describe Summary = Summarize (option stated in parentheses) i. Identify and describe (or provide summary description of ) the real estate. ii. State real property interest [fee simple, leased fee, leasehold, etc.]. iii. State purpose and intended use of appraisal. iv. Define the value to be estimated [see Item d above]. v. State effective date of appraisal and date of report [transmittal date]. vi. State (or summarize) the extent of the process of collecting, confirming, reporting data. vii. State all assumptions and limiting conditions that affect the appraisal. viii. Describe (or summarize) the information considered, the appraisal procedures followed and reasoning that supports the analyses, opinions, and conclusions. ix. Describe (or summarize) the opinion of highest and best use [when appropriate]. x. Explain and support the exclusion of any of the usual valuation approaches. xi. Describe (or summarize) any additional information appropriate to show compliance with the specific guidelines of Standard 1 [or explain permitted departures]. xii. Include a signed certification in accordance with Standards Rule 2-3. Content Issues Significant mathematical calculations presented clearly and accurately. Report sections are consistent and reconcile without contradicting information. Value conclusion reconciles with value range from approaches used and is logical. Yes No Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Appraiser/Firm DIMENSION 5 - 66 REVIEWER CONCLUSIONS Yes Appraisal Acceptable as Submitted. If no: attach rationale or comment on reverse. Appraisal Acceptable after Correction/Resubmission by Appraiser. If yes: attach letter transmitting appraisal and reviewer comments to appraiser. Date of Review Reviewer Signature Reviewer Name CRC US Body of Knowledge Attachment: Yes # of Pages No No DIMENSION 5 - 67 COMMERCIAL APPRAISAL UNDERWRITING FORM Borrower Loan Officer Property Address Report Date Effective Dates Appraiser/Firm Property Type Environmental Issues Identified in Appraisal (Property rights appraised) Yes No Same as Borrower Interest in Property Yes No Economic Characteristics Match Market Perspectives of Bank Yes No Neighborhood Characteristics Consistent with Use of Property Yes No Zoning Allows Present Use of Property Yes No If no: Can improvements be re-constructed if damaged Yes No Site shape/topography suited to present use Yes No Excess land for present use Yes No Building repairs required Yes No Highest and Best Use Yes No Consistent with present use Yes No If vacant land, when can development potential be realized Yes No Cost approach developed: Yes No Site value contribution Yes No Indicated value Yes No Sales comparison approach developed: Yes No Yes No Yes No Size of Site: Land/Bldg Ratio Size of Buildings: No. Of Buildings: No. Of Sales: Unadjusted Range in Unit Sale Prices Do sales compete with subject (similar size, type, location) Adjusted Range in Unit Values Indicated value Income capitalization approach developed: Estimate of Market Rent If leased, is Contract Rent at or near Market Rent Yes No N/A If owner-occupied, can Borrower afford to rent own building Yes No N/A Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Exposure Time Associated with Value Estimate DIMENSION 5 - 68 Direct capitalization and DCF analysis (upon stabilization) DCF analysis (on completion) Effective gross income (EGI): Year 1 EGI: Operating expenses: Year 1 exp: Overall cap rate: Discount rate: no. of years: Indicated value: Terminal (reversion) cap rate: DCF analysis year 1 cash flow: Indicated value: Indicated value: Implied year 1 cap rate: Yes Is/are capitalization rate(s) consistent with loan rate structure Final Estimates of Value: Attachment: CRC US Body of Knowledge Cash Flow Yes # of pages No No DIMENSION 5 - 69 [ ] BANK: BUSINESS LINE RESIDENTIAL APPRAISAL REVIEW FORM Borrower Officer Property Address Report Date Effective Date Value Estimate 1-Family Property Type Condo _____ 2-4 Family _____ NOTE: Attach Explanation for any No and/or ? Responses Content Issues 1. a) Correct form report used for property type being appraised? b) SUBJECT section of form completed in full? 2. NEIGHBORHOOD location, analysis, land uses, changes, occupancy complete? a) Are comments descriptive, informative, pertinent, conclusive? 3. SITE DESCRIPTION complete? a) Zoning identified and conformity/compliance stated? b) FEMA Flood Hazard information completed? c) Highest and Best Use same as present use or explained if different? 4. IMPROVEMENTS description, exterior/interior, complete and acceptable? a) Age and effective age estimate appear reasonable? b) Do comments address: i. Additional features, repairs required, modernization? ii. Physical, functional, external adequacies/inadequacies? iii. General market conditions? 5. COST APPROACH a) Building sketch calculations shown? b) Same gross living area (sq.ft. living area) used throughout report? c) Do cost calculations appear reasonable and are they mathematically accurate? d) Are depreciation factors consistent with improvement descriptions? Yes No Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Appraiser/Firm DIMENSION 5 - 70 6. SALES COMPARISON APPROACH a) Are comparables recent and similar to subject in location, site size, improvement size/room count, amenities, etc. or are differences adequately explained? b) Are adjustments reasonable, logical, consistent, and mathematically accurate? c) Are individual adjustments under 10% of comparable sale price or explained if over? d) Are net adjustments under 15% of comparable sale price or explained if over? e) Are gross adjustments under 25% of comparable sale price or explained if over? f ) Do comments explain atypical adjustments, add additional information, and/or clarify analysis as/if needed? 7. INCOME APPROACH Applicable _____ Not Applicable X 8. RECONCILIATION discusses approaches to value and provides supported conclusion? 9. Is the estimate of market value stated with an appropriate effective (as of ) date? a) Is value within price range of neighborhood as stated in report? 10. Addendum include photographs of subject and comparable sales; interior sketch of subject with exterior dimensions; map locating subject and comparable sales; correct Definition of market value; signed and dated Certification and Statement of Limiting Conditions? Appraisal Acceptable as Submitted Appraisal Rejected (attach list of reasons for rejection) CRC US Body of Knowledge Reviewer Signature Reviewer Name Date of Review