Risk & Business Magazine CEO/CFO Business Today Magazine Summer 2018 | Page 30

INVESTMENT PROPERTIES BY: BRIAN E. HALL VICE PRESIDENT, CORPORATE BANKING, OHIO VALLEY BANK Cap Rates for Investment Properties: C apitalization Rates (Cap Rates), the standard-bearer and primary valuation concept and tool for evaluating investment properties, remains one of the most difficult and often times misrepresented value assessment processes. Everyone involved — including bankers, realtors, investment property owners, professionals, and even appraisers — has a mixed set of standards and perspectives, which can result in wide variations of opinion about a property’s value. This article seeks to share a common- sense approach to the use of this most valuable tool in the evaluation process, placing greater emphasis on the understanding that it is just that — a tool. A piece of the puzzle in evaluating properties as investment opportunities. The practical methodology suggested here is a function of my experience over many years of reviewing properties, sometimes the same property, with multiple owners, covering fairly significant changes in local and national economic conditions. This extended view — meshing the often divergent influences of investor, lender, and appraiser, and the variability between local economic conditions overlaid with a more regionalized conceptualization of cap rate tendencies — can provide a valuable, more homogenous perspective that usually results in a better final assessment leading to more realistic investment results. I argue that equal emphasis must be placed on the core factors that are used in the cap rate model. Specifically, market conditions locally, revenues and their durability over time, and expenses and their potential future influences. 30 The Forest, The Trees, and All That’s In Between THE FOREST The landscape that is Cap Rates is littered with misconceptions, generalizations, over-simplifications, and misrepresentations. One of the primary factors negatively influencing cap rates as a valuation tool is the mind-set that seeks to obtain an absolute factor for a given property. Principal amongst these is the baseline exercise of establishing a range or average cap rate given the property type almost always as a function of regionalized data often well beyond the geography of southeastern Ohio. This can be dangerous and overly optimistic given the long-term nature of the more generally depressed economic conditions in our communities. This urban/rural tension must be balanced by local factors. Understanding these local influences is central to a proper balancing of regionalized cap data as an influence on local market conditions. This is particularly evident and a concern in the appraisal process, as often times the lack of local certified general appraisers results in assignments given to appraisers from urban/metro markets as far away as Columbus and Cincinnati. It can be difficult for these appraisers to fully grasp the local market dynamics influences by varying degrees of depressed economic conditions offset by an insulated, inventory-driven demand with proprietary underpinnings. These influences are often misunderstood and understated in our area. An “average” of regionalized cap rates is invariably used with little or no consideration of these local market influences—both positive and negative. Generally, the loss of homeownership and resultant strong increase in rental housing in urban markets, as a function of the great recession of 2008–10, has served to create what is likely an unsustainable bubble in cap rates for residential rental properties. It is not unusual to see cap rates as low as 5 for these types of properties, and this should be a point of emphasis given that cap rates for similarly constituted properties was as high as 11–12 in the last 10 years. The regional urban/metro data extrapolated from this phenomenon is dangerous and could have the unintended consequence of value fluctuations over time that make real estate markets behave more like Wall Street investments, with their inherent and often unsubstantiated value fluctuations. Past experience in the sha