Last year I was at one of the Bisnow Multifamily Summits at the St. Regis Hotel in Atlanta, Georgia for a panel discussion. A question posed to the panelists was, “How were they underwriting their exit cap rates?” Norman Radow of the RADCO Companies gave such an insightful answer which was “Well, it depends on what income you’re capping.” He went on to describe how he had seen offering memorandums where brokers were capping a variety of incomes whether it was based on the trailing twelve month, the trailing three month, the current month annualized or even a forward twelve month which is pretty unusual.
When we are looking at market area comparisons to figure out the going capitalization rate to apply to a property, we also need to consider how those buyers and sellers arrived at the income. Essentially, cap rates tell one half of the story which is the ratio of the property’s net operating income (NOI) to its sale’s price, but not how the seller or buyer arrived at the income they are capitalizing. Did they use the trailing three month income and apply trailing twelve month expenses? Did they use just a straight up trailing twelve month income statement? Did they annualize the current month’s NOI and then apply trailing twelve month expenses? Did they go off a forward twelve month proforma?
The nuances don’t end there. Some very sophisticated buyers will apply varying historical annualizations to different line items on the income statement. I’ve seen a buyer do a trailing three month of the rental income but then apply a trailing twelve month to the RUBS (ratio utility billing system) income under the logic RUBS income is cyclical and rental income is not; therefore, to forecast the RUBS income you need to look at the entire year and not just the last three months. Bad debt is another line item I’ve seen singled out for a trailing three month, because it painted the most accurate picture of the current tenant profile. All these adjustments impact the bottom line which in turn affects valuation.
In sum, the subjective approach to calculating the income of a property may mean the cap rate is a coincidental rather than a determination factor which hides more than it reveals.