Over the last year, we have seen cap rates increase modestly for all real estate investments. Investors are focusing on in-place returns and capping net operating income (NOI) approximately 100 to 200 basis points higher than the preceding year.
One method investors used for the last 20 years is discounted cash flows (DCF), which is a projection of how a real estate property will perform over time and the return thereon. DCF includes not only today’s rents and expenses but also the growth of future rents, tax assessments, lease-up, and the value of the facility at the end of the hold period.
For office, retail and industrial, many investors create a 10-year DCF with a residual amount at the end of the term. A typical lease term for tenants is five to seven years. By having a 10-year DCF, an investor can incorporate tenant improvements and leasing commissions in their projections with the majority of the tenants expiring/renewing at least once.
With long-term leases, the typical real estate investment will be slow to capture the upside in value as the market recovers. Over the next couple of years, many leases will be signed at lower rental rates, locked for the next five to seven years.
Investors have usually put emphasis on the DCF with 50 percent of value derived from existing cash flow and the other half from the residual value. When the markets peaked in 2006-07, many investors lowered their cap rates and put more emphasis on the residual value. This was accomplished by initially low cap rates when purchasing the property, along with increasing rental rates and occupancy over the next 10 years for an aggressive residual value. The split dropped as low as 20 percent on cash flow to 80 percent residual—on a 10-year DCF. We are now seeing a shift back to a 50-50 split.