The Answer Is 9

Summary

• Why would a Harvard professor give his students the answer to a final exam question?”.
• As a REIT analyst, I use cap rates on a daily basis for comparing the values of various buildings that are bought and sold.
• Structural changes in the commercial real estate business have permanently lowered investor risks, justifying lower returns.
• But maybe, just maybe, the new answer is EIGHT!

When I was in college many moons ago I remember reading an article about a Harvard professor who taught his MBA students real estate capital markets. The professor, Bob Ellis, would always start his class by asking his students the question, “How many of you would like to make a lot of money selling properties you have been leasing?”

Of course that was the attention grabbing question and when the room became silent Ellis replied, “The answer to the final exam will be “nine ”.

As the story goes, Ellis went on to explain that he would be teaching the students about real estate over the next few weeks and at some point the subject of “cap rates” would be discussed. He said that he was going to lecture on a variety of real estate asset classes (hotels, office buildings, etc…) and when he was finished he would give a final exam in which he would ask the students “what is the average cap rate for all of the buildings we discussed?”

Of course, as I read the article (over two decades ago) I told myself, “why would a Harvard professor give his students the answer to a final exam question?” Before I explain the purpose behind Ellis’ free exam question, let me explain the purpose for cap rates in the real estate world.

Understanding Cap Rates

There are many ways to value real estate, broadly speaking, and that consists of appraising the land and building, comparing comparable properties, or calculating the value based on the rents being generated.

The later method is where cap rates come into play. By examining the actual income (or rent) that the property generates and then deducting operating expenses (not including debt costs), the investor arrives at a property-level net operating income (or NOI). Once you determine the NOI, you simply divide that by the cost of the property (that is what’s the price you are buying or selling the subject building). I ran across this infographic:

While this method of valuation may appear simple, the use of the tool can be extremely valuable. As a REIT analyst, I use cap rates on a daily basis for comparing the values of various buildings that are bought and sold. In general, a lower cap rate indicates there is less risk associated with the investment (due to increased demand) and a higher cap rates can be associated with higher risk alternatives.

For example, Gladstone Commercial (GOOD) is a Net Lease REIT that invests in free-standing properties. The buildings that GOOD acquires are not what I would consider to be trophy properties and the tenants are generally non-rated. What that means is that GOOD’s tenants are higher risk and that translates into higher cap rates. In 2016 GOOD acquired properties at an average cap rate of 8.4%

Alternatively, Realty Income (O) also invests in single-tenant properties with long-term leases contracts. Many of Realty Income’s tenants are investment-grade rated and the risk of tenant default is much lower than for GOOD. As an example, Realty Income invests in stores leased to Walgreens (WAG) and the cap rates for these properties are selling at around 6%.

On the surface, one would think that GOOD would produce better profit margins that O because the cap rates are higher.

That’s wrong, because GOOD is not only taking on more tenant risk, but the company is taking on more balance sheet risk.

GOOD’s weighted average cost of capital (or WACC) is much higher than O, so the profit margins (for GOOD) are not as “good” (as O). In April I explained as follows,

Realty Income's weighted average cost of capital is around 4.4%, the lowest of any Net Lease REIT peer. However, GOOD's WACC is significantly higher, around 7.5%.

For Realty Income to earn profits, the company invests in high-quality buildings with cap rates of around 6.5% to 7%. That means that the profit margins are around 210 bps and the buildings are leased to credit-worthy customers.

I added that,

GOOD is also taking on considerably more risk with its higher leverage. In other words, its WACC would be around 8.5% if it were to use more conservative leverage like Realty Income (33% equity). So it's important to recognize that GOOD is generating investment spreads of around 100 bps (8.5% cap rate - 7.5% WACC) with substantially more balance sheet risk AND tenant risk.

So, one component for utilizing the cap rate methodology is to assess certain risk factors such as creditworthiness of the tenant, quality of the location, and local market factors.

The Answer is Nine

A few years ago I was reading an editorial by Steve Steppe in Real Estate Capital Markets Report called The Answer is Nine (*). In that article, Steppe described a simple method of predicting markets:

In 1971, when I was still a young leasing broker for Coldwell Banker in Southern California, I signed up for my first investment training class. The class was being taught by a very bright Harvard MBA who ran the newly formed Investment Department at Coldwell Banker.

Bob Ellis, starting the class by asking the question 'How many of you would like to make a lot of money selling properties you have been leasing?' Obviously, everyone's hand went up.

At that point, Bob said that the answer to the final exam for the class would be 'nine'. Now, to say the least, it was unusual to be given the answer to a final exam before the class began. So, we waited patiently for an explanation.

The next two weeks were spent on case studies of actual sales. And in every case we studied, the cap rates always either were over or under 'nine.' So much for being given the answer to the final exam up front.

As we soon learned, however, the answer to these cases really was 'nine'.

For example, whenever we researched and analyzed a property that sold for a reported seven percent cap rate and brought the rents to current market, the actual cap rate at current market rents would be 'nine.'

If transactions were completed at 10 percent to 11 percent cap rates, we always found it invariably was due to over-market leases that would adjust down or, at best, remain at the same rent when they were renewed. And, whenever we made those adjustments, the answer was always 'nine.'

Even today when I read this ancient (1971) article by Steppe, I find wisdom in his words and his strategy that returns will eventually move back to higher historic cap rates, perhaps not 9 percent, but higher than today's 6 or 7 percent.

As Steppe argued, returns on commercial real estate may dip during cycles but will always rebound to the historic average. Accordingly, now that interest rates are rising, there is a strong possibility of a substantial adjustment in pricing over the intermediate term.

However structural changes in the commercial real estate business have permanently lowered investor risks, justifying lower returns. The efficiency of information, the specialization of capital, the domination by institutions instead of entrepreneurs - all these things have produced lower risks.

If you have lower risks, you should not expect to get the same returns you got a decade ago and we may never go back to a 9 percent world….but maybe, just maybe, the new answer is EIGHT. Let me know what you think….

My latest Realty Income article HERE

My latest Gladstone Commercial article HERE

Disclosure: I am on the Advisory Board of the NY Residential REIT, and I am also a shareholder and publisher on theMaven.

To learn more about my REIT Beat service, click here. For a limited time, I am providing new subscribers with an autographed copy of The Intelligent REIT Investor. This is a limited offer, so don't miss out!

Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos and be assured that he will do his best to correct any errors if they are overlooked.

Finally, this article is free and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

Disclosure: I am/we are long APTS, ARI, BRX, BXMT, CCI, CCP, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRM, JCAP, KIM, LADR, LTC, LXP, O, OHI, PEB, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, UBA, VER, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.