Residential Real Estate

Capitalization rates reflect the degree of risk associated with an investment. Net operating income divided by the capitalization rate equals value.

Beginning in 2008, and carrying over into 2009, market conditions have led to a noticeable increase in capitalization rates. These trends are a function of increased risk perceived by investors and more stringent lending conditions implemented by financial institutions.
As will be shown on the following pages, based various sources, capitalization rates have increase from about 50 to 150 basis points during the past 12 to 15 months. The result is that property values have declined commensurately.
The upward trends in capitalization rates are evident from several different perspectives:

1. The most common method for analyzing capitalization rate from a financial position is the Band of Investment Analysis.

Also known as the mortgage equity analysis, this technique divides the net income between debt and equity positions. Available financing and required investor equity dividend rates are the components of this analysis. Current loan terms would be in a range of:

Mortgage Ratio: 65%
Amortization Period: 25 years
Mortgage Interest Rate: 6.5%
Mortgage Constant: 0.0810
Equity Dividend: 0.0800


These terms are used in the mortgage equity calculation, which is presented below:


BAND OF INVESTMENT TECHNIQUE
Component % X Rate = Weighted Average
Debt 65% X 0.0810 = .0527
Equity 35% X 0.0800 = .0280
.0807
Indicated Rate 8.1%


A year ago rates would have been more similar to:

Mortgage Ratio: 75%
Amortization Period: 25 years
Mortgage Interest Rate: 6.0%
Mortgage Constant: 0.0773
Equity Dividend: 0.0700


Using these terms in the mortgage equity calculation, the indicated capitalization rate is 50 basis points higher:


BAND OF INVESTMENT TECHNIQUE
Component % X Rate = Weighted Average
Debt 75% X 0.0773 = .0580
Equity 25% X 0.0700 = .0175
.0755
Indicated Rate 7.6%


This analysis shows that even a slight change in the interest rate, or loan to value ratio, places upward pressure on the capitalization rate.


2. Comments from brokers in late 2008 and early 2009 indicate rates have increased about 100 basis points in the past 12 months, meaning a property that once traded at a 7.0% cap rate would now sell for 8.0%.

One broker with Capital Pacific commented in March 2009 that rates for triple net leased real estate would likely be in a range of about 7.5 to 8.5%.

Another retail broker, Kevin Hemstreet, sold two triple net properties in August and September 2008 at cap rates of 6.6% and 6.9%, felt that cap rates would be between 7.75 and 8.0% today.


3. Korpacz Investor Survey, is a national survey of real estate investors and portfolio managers which shows a similar trend. The survey results pertaining to the National Net Lease market from the 1st Quarter 2009 are summarized below:

NATIONAL NET LEASE MARKET
Cap Rate Range Avg. Cap Rate
1st Quarter 2009 6.0 to 10.0% 8.58%
4th Quarter 2008 6.0 to 10.0% 7.85%
3rd Quarter 2008 6.0 to 10.0% 7.65%
2nd Quarter 2008 6.0 to 10.0% 7.63%
1st Quarter 2008 6.0 to 10.0% 7.63%
Source: Korpacz, 1st Quarter 2009 Investor Survey

This data reveals that average capitalization rates for the National Net Lease market have increased about 95 basis points over the past year.



4. Regional net lease sales also provide strong evidence of upward trends. Investor purchases of fast food restaurant buildings with triple net leases are charted below.


TRIPLE NET LEASE SALES (1/08 TO 1/09)

Sale Year Cap
Date Tenant City State NRA Built Sale Price PPSF Rate
1/22/08 Carl's Jr McMinnville OR 2,657 2007 $1,820,000 $685 6.0%
2/15/08 Izzy's Salem OR 5,154 1982 $1,750,000 $340 5.0%
3/3/08 Starbucks Syracuse UT 1,750 2007 $1,300,000 $743 6.2%
4/4/08 Applebee's Pasco WA 5,415 2005 $2,625,000 $485 6.9%
4/24/08 Jack in the Box Grants Pass OR 2,662 2006 $2,120,000 $796 6.2%
5/22/08 KFC/Taco Bell Port Angeles WA 3,200 1990 $1,335,000 $417 6.0%
6/3/08 Jack in the Box Vancouver WA 2,654 2007 $1,215,000 $458 5.6%
7/23/08 El Pollo Loco Vancouver WA 2,844 2008 $2,600,000 $914 6.7%
8/22/08 Jack in the Box Klamath Falls OR 3,000 2007 $2,400,000 $800 6.5%
9/23/08 Arby's Grants Pass OR 2,700 2008 $2,100,000 $778 7.1%
12/1/08 Shari's The Dalles OR 4,950 2008 $1,800,000 $364 7.7%
1/29/09 Taco Johns Kennewick WA 1,768 1981 $857,000 $485 7.3%
Source: PGP Valuation/Capital Pacific

On the following page, the above data is plotted into a regression analysis, which clearly shows the upward trend in cap rates.


Based on this data, as of about one year ago, capitalization rates were about 5.75% and today would be about 7.5%.

5. Impact on Value The relationship between capitalization rates and value is inverse and can be significant because capitalization rates are a highly sensitive input into the calculation of value. Therefore, a slight increase in capitalization rates can have a dramatic downward effect on value.

For example, if a property generating $100,000/year in NOI was purchased early 2008 at a 6.5% capitalization rate, the sale price would have been about $1,540,000 ($100,000 / 0.065). Today, at a capitalization rate of 7.5%, the value would be about $1,330,000 ($100,000 / 0.075). That suggests an erosion in value of $200,000, or about 13% ($210,000 / $1,540,000).

6. Looking ahead investors surveyed in the 1st Quarter 2009 Korpacz Investor Survey said they expect rates to increase another 50 basis points over the next 6 months. Again, these upward increases in cap rates are tied to economic conditions and more stringent lending requirements.

Reid Erickson
PGP Valuation Inc.
206.965.1106
Reid.Erickson@pgpinc.com