Risk & Business Magazine CEO/CFO Business Today Magazine Summer 2018 | Page 31

INVESTMENT PROPERTIES
THE TREES
The concentration of thought on a
suitable cap rate in the appraisal process
— whether by the appraiser, the banker,
or the investor — overshadows and
often times completely renders moot
the analysis of expenses and revenues
associated with the subject property. I
would argue that a thorough vetting of
revenues and expenses is significantly
more important than arguing whether
a property is a 6 cap or a 7. Variability
in expenses and potential volatility in
revenues based on a variety of factors,
combined with the inherent variable and
judgmental nature of cap rates, introduces
what our middle-school science teacher
always told us to eliminate — too many
variables in one experiment.
So often, general average percentages
are plugged into an expense calculation
that can significantly misstate the actual
long-term operational reality. To use
a standardized “percentage allowance”
for maintenance and repairs in this
environment is ill advised. The prudent
investor will devote great attention to
understanding expense dynamics for a
property, distilling even such seemingly
innocuous minutia as the walking
distance from the property to centers of
social engagement.
Experienced investors will demand
verifiable seller financial documents that
demonstrate the long-term historical
experience for all expense categories.
Drilling down even further, they will
make assessments and judgments
about the level of deferred maintenance
accumulated in the property which
generally manifests itself in an
abnormally lower expense experience for
maintenance and repairs.
Almost always left out of the process is
the consideration of Capital Expenditures
(Cap Ex). It is rarely even mentioned in
appraisals. Invariably, when it is included
in the evaluation model, it is expressed
as an “average allowance” with no noted
consideration given to the age of the
property, deferred maintenance, or
obsolescence factors. Investors, quick to
account for depreciation as a tax-saving
enhancement to cash flow, rarely consider
the opposing half of this long-term asset
evaluation (i.e., Cap Ex).
On the revenue side of the equation,
investors should assess market influences
which might impact future revenue
streams. Population growth or decline,
elasticity of competitive entries into the
market, inherent geographic limitations,
and institutionally imposed policies are
amongst the many considerations that
should be evaluated for revenue stability
and growth. Lastly — and one of the
most underevaluated considerations — is
future revenue growth combined with
stress testing for revenues and vacancy.
These are factors that banks routinely
emphasize but rarely receive the scrutiny
commanded by cap rate determinations.
I would argue that a more focused and
detailed understanding of revenues and
expenses is as important as a cap rate
evaluation. A deterioration in revenues
or increased expenses jeopardizes cash
flow just as much or more than the
debt payments associated with a given
valuation assessment predicated on
cap rate analysis. The underpinning of
an unsuccessful investment property
experience is invariably a function of
reduced revenues and/or increased
expenses, and what the property was
originally valued at rarely enters that
difficult conversation, at least until the
bank must try to remarket the property
through a foreclosure action.
ALL THAT’S IN BETWEEN
value to be used, often to the complete
exclusion of other property performance
considerations. This phenomenon is
exacerbated by a regionalized average
cap rate methodology, sometimes
unrealistically influenced by temporal
market conditions not germane or
applicable to southeastern Ohio.
Regulatory requirements mandating
appraiser certification standards
effectively have eliminated local
appraisers as conduits of evaluations in
our local communities for investment
properties, thereby shifting and creating
a paradigm of influence by valuation
sources typically much less familiar with
local market conditions and changing
local market dynamics in southeastern
Ohio. This can, and does, arbitrarily
impact cap rate consideration both up and
down.
Increases/decreases in revenues and
expenses and future considerations of
these factors are equally influential and
impactful to cap rate considerations. A
thoughtful, thorough consideration of
property performance dynamics and the
employment of “what if” considerations
for revenues, expenses, and other market-
centric influences will create a range-
of-value perspective eliciting a more
informed purchase decision.
In the final analysis, the ultimate
consideration must be driven by the
quality of the investment which should be
largely defined as cash flow. An aggressive
cap rate assessment which elevates the
property value requires the investor to
decide if the reduction in return on the
property, either as a function of cash flow
through a larger credit facility or in terms
of a greater up-front investment of equity
capital, warrants consideration of the
purchase. +
Cap rate fixation often manifests itself in
myopic disagreements over the “correct”
Brian E. Hall is Vice President, Corporate Banking, for Ohio Valley Bank. Ohio Valley Bank operates 19 offices in Ohio and western
West Virginia. Hall is based at the Ohio Valley Bank Athens Loan Office. He is a graduate of The Ohio State University and is an
experienced business financing expert.
Hall is extremely active in his community. He is a past president of Rotary, has volunteered with Big Brother/Big Sisters of Athens
County, and is active in mentoring students to improve their reading skills