Every now and again, I stumble on something that just doesn’t seem to make full sense. Today it was a couple of paragraphs on a highly ranked website about capitalization rate influences and property value increases. It’s written in a doctoral-level tone with the appropriate PhD citations, so it strikes a tone that everything it says is true. Leave it to me to debate some of its tenets.
Another factor that may affect the investor’s required rate of return, and therefore, the capitalization rate, is expected appreciation. Investors make their decisions based on the total expected return, which is the sum of income return and appreciation return. To understand how expected appreciation may affect the market capitalization rate, consider an investor who requires a total return of 12% on his/her investment. In evaluating a property for acquisition, the investor is told by a real estate advisor that the expected appreciation rate for the property is estimated at about 3%. Given the total return requirement of 12%, the investor will buy the property only if it is priced so that it offers a 9% (twelve percent minus three percent) income return, at least. If the investor’s consultant estimates expected appreciation at 5%, the investor would be willing to accept a lower income return and buy the property at a price that corresponds to a capitalization rate of 7%.
The bottom line is that when market-wide expectations of value increases are high, market capitalization rates should be low; when the expectations for value appreciation are low, capitalization rates should be high.
This whole situation is a lot like the Biggest Cap Rate Misconception on the Planet blog series that I critiqued in depth.
The thing that just doesn’t jive for me is the simplicity of subtracting the appreciation rate from the investor’s required return to come up with the cap rate he/she is willing to buy a property for. During the hot real estate market prior to 2006, this was a neat and clean way of supporting the aggressively low cap rates that properties were selling at, but I just had to run the numbers. Let’s test this theory out.
Not Appreciating Appreciation
Before I get into the numbers in Part 2, I already have some small issues with the formula. The first is that if you’re buying with appreciation expectation, you’re obviously expecting to sell it otherwise you won’t realize your gain, which is a part of your total return. If you sell it, you’ll likely do it with a broker so the broker’s commission is not considered. Nor are closing costs. The second problem is that there’s nothing in there about the cap rate that the next buyer is going to buy the property for. Let’s say it’s the same cap rate and pick one of the examples above, the 12 percent return and the 9 percent cap rate with 3 percent for appreciation. So what you are also saying is that the next buyer will have the exact same total return requirement. Hmmm… how lucky is that? If the next buyer has a 14 percent total return requirement and the same 3 percent appreciation expectation, that means they will buy the property for an 11 percent cap rate, not a 9 percent cap rate. There is just no way that the original buyer is going to get his/her 12 percent return if they have to sell it at a cap rate two percentage points higher. My final conceptual problem is that much of the return is realized one year into the future (assuming that selling one year into the future is the the intention of the buyer), yet a dollar a year from now is not worth a dollar today. That’s what discounting is for.
OK, now that I’ve got my conceptual beef out of the way, in Part 2 I’ll put this theory to the test using mathematics. Curious what the result will be? Let’s find out together.
