The income approach and, more specifically, direct capitalization, is the method most often used by investors, lenders, brokers and appraisers. The principle of direct capitalization is simple, yet it is repeatedly misapplied, even by professionals.
Direct capitalization involves the use of rates, i.e., cap rates, to capitalize the property's single-year net operating income into a value estimate. The process is very easy:
- Value = net operating income / capitalization rate
If the subject's net operating income is $125,000 per year, before debt service and depreciation, and if the cap rate is 10 percent, then the indicated value would be $1,250,000 ($125,000/0.10).
Deriving Cap Rates
A capitalization rate is one that relates a single year's net income to value. The cap rate is the result of investors' actions in the marketplace. It goes down when investors think values are going up and, conversely, it goes up when investors believe values are going down. All the investors' motivations and assumptions about growth in revenue, expenses, etc., are built into that single capitalization rate. It includes expectations of both a return on and a return of the investment.
The most commonly used method of deriving the cap rate is from the analysis of comparable sales. The rate is determined by dividing the sale property's net income by its sale price. In the above example, the rate is determined as follows:
- Net operating income / sales price = capitalization rate
($125,000 / $1,250,000 = 0.10 or 10%)
Limitations on Use of Cap Rates
Direct capitalization can only be used on facilities that are stabilized, i.e., facilities that have reached their optimum level of performance. If a facility is still in its lease-up stage, one must first determine the level of stabilized net operating income and then capitalize it into the value estimate. Once a stabilized value is determined, the lease-up costs necessary to achieve that level of income must to be deducted to determine the facility's "as is" value. Obviously, an investor will not pay as much for a facility that is half empty as for one that is full.
- Stabilized net income ($95,000) / cap rate (10%) = indicated stabilized value ($950,000)
- Indicated stabilized value ($950,000) - lease-up costs ($70,000) = indicated "as is" value ($880,000)
The sales price in the above example is $880,000. Anyone analyzing this sale without the knowledge that the facility was in lease-up and the net income was an estimate of its stabilized level and not actual current net income, would conclude the cap rate was 10.8 percent ($95,000 / $880,000 = 0.108 or 10.8 percent). The real cap rate the buyer anticipates receiving is 10 percent.
Another example of the limitation on the application of direct capitalization involves a facility that has excess land. Assume, for instance, an owner wants to sell a facility, and it has a stabilized net operating income of $95,000. In addition, there are two acres of excess and vacant land valued at $175,000. The proper application of direct capitalization would be first to capitalize the net income and then add the value of the excess land as follows:
- Net income ($95,000) / cap rate (10%) = value excluding excess land ($950,000)
- Value excluding land ($950,000) + value of excess land ($175,000) = indicated total property value ($1,125,000)
The uninformed analyst who happens on such a sale often misinterprets the resulting cap rate by dividing the known net income by the sales price ($95,000 / $1,125,000 = 0.084 or 8.4 percent). It was never the intent of the buyer to only receive an 8.4 percent return. This is the cause of so much confusion and misunderstanding in today's self-storage marketplace. Too often, people lack the detailed knowledge of the improved sales on which they rely to determine value.
Many factors prevent facilities from being suitable to employ direct capitalization to determine value. For instance, facilities that have excess land, deferred maintenance or are being mismanaged are not suitable for direct capitalization without making considerable additional analysis.
Problems in the Application of Cap Rates
Most of the problems with the direct-capitalization method come from the inconsistencies in its application. The method by which the cap rates are derived and the manner in which they are applied to the subject's income stream must be consistent.
For example, if the cap rates are derived from sales that included reserves for replacement as a line-item expense, the cap rate should be applied to an income stream that includes reserves as well. By the same token, if the cap rate derived from the sales data was based upon "trailing" net incomes, the rate selected should be applied to the subject's trailing net income and not the pro forma, or forward-looking, net-income estimate.
Some investors look at the "trailing cap rate," which is derived by dividing the property's trailing 12-month actual net income by the sales price. This rate can be very misleading, as the seller often anticipates different income and expenses than the property's historical performance. Most buyers are looking for facilities to purchase where they believe they can improve on operating performance.
The following actual transaction demonstrates how easy it is to go from the 9 percent trailing cap rate the sellers thought they received to a 10 percent forward rate the buyers believe the transaction will provide.
Trailing 12-Month Actual
- Scheduled rental income ($420,000) - vacancy (15 percent) ($63,000) = effective gross income (revenue) ($357,000)
- Effective gross income ($357,000) - expenses ($135,660) = actual net operating income ($221,340)
The sale price was $2,475,000, all cash, so the indicated "trailing cap rate" was 8.9 percent, calculated as the net income divided by the sales price ($221,340 / $2,475,000 = 0.089 or 8.9 percent).
The buyers had something else in mind when they paid $51.56 per square foot. They planned to increase revenue 5 percent by increasing scheduled rents that were below market by about 1 percent, and they planned to increase occupancy 3 percent by managing the facility more effectively. The buyers also felt they could do a better job of managing the controllable expenses and would save approximately $1,000 per month. Therefore, the net operating income would increase by $28,768 per year, or 13 percent. The resulting impact on the indicated cap rate is shown as follows:
Buyers' Pro Forma
- Scheduled rental income ($424,200) - vacancy (12 percent)($50,904) = effective gross income (revenue)($373,296)
- Effective gross income ($373,296) - expenses ($123,188) = actual net operating income ($250,108)
Therefore, the indicated forward-looking cap rate is 10.1 percent ($250,108/$2,475,000 = 0.101 or 10.1 percent).
The price paid in any transaction reflects the perceived risk in the deal. In this case, the buyers felt they could easily achieve their planned increase in net income. They were even willing to pay slightly more if necessary. The sellers sold too low, because they relied on what they had heard in the marketplace, i.e., a 9 percent cap rate is good. The problem was the sellers applied the 9 percent cap rate to the trailing net income and it should have been applied to the forward-looking or pro forma numbers. The most important part of the lesson is the price per square foot does not change; the buyers still paid $51.56 per square foot.
This example also illustrates the wide spread between the bid and the ask prices in today's marketplace. Often sellers confuse the generally low trailing cap rates with forward-looking rates. The result is they are saying to the buyers, "You take all the risk of achieving the higher income." But in the real world, the person taking the risk gets the reward.
Had the sellers determined a 9 percent cap rate and properly applied it to the forward-looking net income, the transaction would never have happened. They were, however, happy with the cap rate of 9 percent, erroneously based on trailing income and, in this case, they left money on the table.
The difference between the "ask" (listing price) and the "bid" (offer price) is the transaction zone. If the spread is too great, deals don't get made. It's time everyone stops listening to the "word on the street" and starts looking closer at their own numbers.
Direct capitalization using a cap rate is a straightforward and easily understood valuation method. The process, however, is often difficult to apply properly.
Every facet of the income statement must be studied to assure the facility is operating on a stable basis. The analyst needs to ask: Are the rents at market levels? Are physical and economic occupancies at their optimum levels? Are controllable expenses being managed properly? Only when the answer to these questions is categorically "yes," and only when there are no other extenuating circumstances such as excess land or the pending impact of a new competitor, can you properly employ direct capitalization to determine value.
Charles Ray Wilson is president of Charles R. Wilson & Associates Inc., an appraisal company that specializes in the valuation of self-storage facilities nationwide. He is also owner of Self Storage Data Services Inc., a research company that maintains a database of operating statistics on thousands of facilities across the country. Mr. Wilson is a member of The Appraisal Institute and holds the MAI designation. He also holds the CRE designation with the Society of Real Estate Counselors. For more information, visit www.crwilson.com.