Many property management companies advertise statements such as, “We treat the properties we manage as if they were our own.” For this statement to be true, property managers must constantly focus on maintaining and increasing the value of the real estate asset they’re responsible for overseeing. For a property manager to be most effective, and to truly treat the properties as if they were her own, she needs to have a fundamental understanding of three key real estate financial concepts: cap rate, return on cost and leverage.
The first and most fundamental concept is the capitalization rate, commonly referred to as cap rate. The cap rate represents the annual percentage return, or yield, an investor will receive if the property were purchased all cash. It is defined as the ratio of net operating income to property value. For example, if Property X was recently built, is producing a stabilized NOI of $500,000, and an investor pays $8.4 million to purchase it, then the cap rate would be $500,000 divided by $8.4 million, or 5.95 percent.
The cap rate is a reflection of the risk inherent in acquiring that particular property – more risk means a higher cap rate. Cap rates vary based on property level risk factors such as the age, occupancy, functionality, location, creditworthiness of the tenants, diversity of the rent roll and length of tenant leases.
For example, if a property is older and has a number of deferred maintenance items, an investor will require a higher return on his investment. Assume that Property Y is 20 years old, has a number of tenants who are struggling financially, and has a significant amount of tenant rollover in the next 24 months. There is more risk in this investment, and therefore the cap rate will need to take these factors into account. If an investor, after taking into consideration all the risk factors, decides she will require an 8 percent yield, the purchase price can be calculated as the NOI of $500,000 divided by 8 percent, which is $6.25 million.
The difference in cap rates between these two examples reflects the different risk premiums associated with each investment. The property with less risk sold for a 5.95 percent cap rate, and the property with more risk sold for an 8 percent cap rate. It is important to note that cap rates also vary based on market-level risk factors such as supply, demand and interest rates.
The second important financial concept is return on cost. Return on cost is simply the ratio of income to cost and is most relevant when discussing new construction projects or capital investments.
For example, let’s assume that Property Y described above requires a capital investment of $750,000 and, as a result of this capital investment, we project the NOI will increase by $75,000 – then the return on cost is 10 percent ($75,000 divided by $750,000). This capital investment would be viewed as positive for the owner because he would be receiving a higher return on this investment as compared to the original purchase (10 percent vs. 8 percent). The return on cost gives you a view of the financial feasibility of a particular project or development and is a key metric when evaluating the cost-benefit analysis of different projects.
The third important financial concept is leverage, or debt financing, which can improve the yield an investor generates from an asset. For Property X, the investor expects a 5.95 percent return, or yield (assuming the property was purchased all-cash).
Now, let’s assume the investor can finance a portion of the purchase price with a bank loan at a 4.5 percent interest rate. This will result in a higher cash-on-cash yield for the investor because the interest rate is lower than the cap rate – 4.5 percent interest rate vs. 5.95 percent cap rate.
However, there is some additional risk to this strategy because the real estate asset is held as collateral by the bank. If the cash flow from the real estate asset declines significantly and the owner is unable to pay the debt service, the bank can foreclose.
Property managers should understand the risks associated with debt and be proficient in calculating key ratios that banks monitor when tracking their borrowers’ loan covenant compliance – key ratios include loan-to-value and debt service coverage ratio.
In order to be more effective as a property manager, you need to have a fundamental understanding of these three concepts. By understanding these key concepts, you will be an asset to your clients and you will be able to answer everyday questions, such as:
My owner is planning to put the property on the market next year. The owner wants to sell the property for $20 million – what NOI will achieve this sale price based on today’s cap rates, and how do I achieve that NOI?
How does this capital expenditure that I am recommending ultimately impact the value of this asset? Is the return on cost for this capital expenditure sufficient?
The loan agreement for my property requires a 1.25 debt service coverage ratio. Will the property be in compliance if my operating expenses increase by $25,000 through the remainder of this year?
By regularly considering and answering these types of questions, managers truly can say they treat the property as if they own it.