# BUY Commercial R.E. NOW as RATES go up and VALUES Fall ?

Hi:

I have a question whether it is a good Time to buy now, with plan to sell in 10 years.
Here is example scenario:

“Market” Interest Rates are approx 5.5% on CD’s/Treasurys, so CAP rates must be higher(obviously , or else everyone just puts case into Bank w/Govt guaranteed rate).
CAP Rates in my area in PA are at approx 7.0% (yes range is approx 6.00 - 8.00%)
If I BUY today a building with CAP rate = 7.00%,
PRICE=\$1M
NOI=\$70,000/yr

## SELL In 10 Years:

In 10 years, if we make the Assumption that Market Interest Rates are higher, and for Discussion lets assume
“Market” Interest Rates are 8.0% on CD’s/Treasuries
So, CAP rates on propeties haveto be HIGHER, so lets add the same 1.5%, so CAP rates would be 9.5%
If my plan is to SELL the building in 10 years, the MARKET value that I could sell for based on CAP rates is:
MARKET VALUE=NOI/CapRate= \$70,000/9.5%= \$736,000.
Since the Value went from \$1M to \$736K, I will have LOST \$264K.

The question is: WHY would anyone BUY today if we see that rates will increase over the next 10 years ?

The answer is: Because most people live in the “HERE and NOW” :biggrin

Markets differ. What works in your town might not work in mine.

I’d think about buying commercial if I could get a true 7 cap rate. Caps around here are about negative 20.

In ten years? Who knows. If there is high inflation, rents will have gone up (you won’t have more than 10 year leases, so time to raise rents in 10 years).

Cap rate has nothing to do with interest rates. Caps have to do with rents and expenses. Just becasue you, personally, have to have more return than a money market account doesn’t mean that every buyer feels that way.

When you buy commercial, there is the potential value of the dirt to consider as well as the income.

Say I buy a delelict feed store building that is losing \$1,000 a month. Bad deal? Maybe not. What if I can pull that old feed store off there in 2 years and build a medical center, because that property is the perfect location and the perfect zoning for a medical center? And also, incidentily, there is nothing else available that is such a good place for a medical center?

You are buying for cap rate. Maybe I am buying for a different reason.

With commercial, I think a bigger worry is recessiion. If recesion gets bad the business that is renting from you might go out of business, then suddenly, you have no income at all from your building.

I think it depends on what each of us thinks of when we hear “cap rate”.

If we are talking about a basically passive investment like a Walgreens changing hands, then the cap rate is a measure of the value of the investment, and interest rates are very directly related to that.

If we are talking about how cap rates are calculated, then interest rates are not involved.

And if we are talking about buying a turnaround situation, that is more of a business and not a passive investment that can be measured by a cap rate.

All IMO of course.

PA Commercial, you are making an assumption that rates are going up. The market in general is not supporting that assumption. Who knows.

-Don

Tatertot…

You are wrong about cap rates. Interest rates have everything to do with cap rates. Income and expenses are also a component.

PA_commercial look back at some of my posts on cap rates, they should help you out.

To figure CAP rates–NOI/salesprice=CAP RATE, if you know the CAP rate for a type of property in the area you are looking at, do the inverse and you will get a sales price.
Interest rates are not taken into account with CAP RATES. They could be seen as a market force.

Um, wrong!!! Cap rates, as previously stated, are solely based on income and expenses.

Negative…

Go look at “Band of Investments”, “Mortgage Equity Analysis” aka Elwood model, and Yield Capitalization.

All NOI/Sale Price does is tell you what cap rate that a single property sold for. Like I said you need to calculate an investment cap rate. There are tons of factors that need to be considered to be as easy as you may like it to be. The funny thing is that CCIM classes last I knew didn’t even teach how to calculate it except for the stuff Texas Broker said which is sad.

In the former models I spoke of consider:

Cost of capital (debt interest rate)
Equity return (required rate of return to investor…aka cash on cash return)
Growth in NOI
Growth in underlying asset (growth in value due to asset appreciation)
Sales costs (broker fees, attorney fees etc…)
Time Value of Money (a dollar today is not worth the same tomorrow)

All this nonsense is even more reason to forget cap rate unless you’re buying a LARGE commercial property. It’s all hocus pocus and foolishness that doesn’t tell you what you really need to know - WHICH IS CASH FLOW. It takes CASH FLOW to run a business. You can try to eat Cap Rate, but it’s not very tasty (unless you add a lot of salt)!

Good Luck,

Mike

Cap rates are a measure of cash flow. A cap rate turns a cash flow into value. Cap rates are definitely not for residential properties.

Cap rates are definitely not for residential properties.

Sean, I think we both agree that cap rates are not for relatively small residential properties.

Mike

Thanks for all comments…but for clarification: CAP Rate is a common metric that Commercial properties are valued with. I compared CAP Rate with market interest rate (yes at a bank for example) because that is what Investors do. Would YOU (or any of us) invest/risk your money for a property investment that has a 5% CAP rate if the Market Rate in a FDIC bank was say 6.00%(since it would pay better, is FDIC insured, backed by AAA US Govt, and requires No work on your part)…thats why CAP Rate is compared vs Market Rate.

As for interest rates, yes they may have been at 30 or 40 year lows for a couple years, and they may haveto teeter lower to regain steam in economy for 1 - 2 -3 years(not discussing that), but in general they cannot fall too much lower…but they Can increase alot.

So, the initial Question is: If Rates go up, and everyone STILL USES the Cap Rate metric to Valuate Comml Properties, won’t the Value go DOWN ? If so, WHY buy when rates are LOW and going up ?

This is over simplified but I think you’ll get the point.

Debt cost = 6%

Required Return on equity = 7%

LTV = 80%
Equity = 20%

.8(.06) + .2(.07) = 6.2%

Think of a cap rate as a weighted average cost of capital…

Good luck

What does 6.2% represent in this equation?

Its a cap rate calculated using “band of investments”.

ok so I did some research on your “band of investments”, “Mortgage Equity Analysis”, etc and this is my conclusion. I would compare your use of the valuation techniques to the way a religion such as Scientology relates to Christianity (disclaimer: I’m using these two religions because one is large and one is small, that’ it). With Scientology you have a small but dedicated group who believe in the religion (your “band of investments”), and swear by it and it’s ability to dictate your actions (your investments) althought noone quite understands what the hell it’s all about.

With Christianity you have an exponentially larger group of people who believe that there is another, right way or doing things. And this method (my cap rate) is widely viewed as the acceptable practice.

In short, this "Band of Investments, “Elwood Model”, mumbo jumbo seems to me like some economists trying to justify an investment. This isn’t real world stuff, and it makes a simple process way to complicated. Keep it simple, stick to the fundamentals, that’s what successful athletes, musicians, investors, etc. do.

That’s an ignorant statement if I have ever heard one. I’m glad you could get meaningful knowledge in 2 days. Stick to what you know and it’s not real estate, you may want to be a minister.

I’m going to go ahead and give a simple example you may be able to understand.

100,000 Sale price
10,000 NOI
10% Implied cap rate (NOI/Sales Price)
12% will be the investors required return to move forward with investment

Investor mortgage info
80% @ 9.0 - Mortgage constant = .0966
80%(.0966)=.0772 pmt=644

Investors goals
12% Cash on Cash
.20(.1234)=.0247 or \$205.66 per month or per year \$2468 to investor

Cash Flow mortgage is consuming = .0772 or \$644 per month or \$7,728 dollars

NOI = 10,000
Total proposed out going cash flow = \$10,196.00

What does this example show you. 1.) That NOI dosent cover debt service and your required return. This would be denied

My point is that taking a listed sales cap rate and us it as your own makes little sense. From your financial standpoint and your credit ability’s may be nothing like the sold one. They may have been leveraged at different levels… I can go on and on. What I can tell you is that your not moving in the right direction by blowing this off.

No, I won’t be getting ordained anytime soon, they would probably kick me out of school. I was just trying to say that the majority of people don’t use this method of valuation. I have not seen one person on here try and backup or state that they use this method to evaluate their properties.

Check this out:
100,000 sale price
10,000 NOI
=10 cap
investor wants 12 cap

take your 10,000 NOI divide by .12 (cap rate) and bam! gives you \$83,333. That tells you what your investor will be willing to pay. It’s that simple instead of diving into “mortgage constant”, etc. Again, you’re making this way too complicated for yourself.

“Keep it simple, stick to the fundamentals” EXACTLY!! K.I.S.S.

The value in the Band of Investment is that it considers the cost of your debt. You can run two weighted averages if a seller second is involved. How will your required return change if you use a hard money lender, as oppose to 100% seller financing at 0% on a 30 year amortization? The BOI tells you that. And truthfully, the BOI isn’t THAT complicated. It’s just a weighted average. I think it still falls under K.I.S.S., for most people anyway…