Commercial real estate investment returns come from two sources, income and capital appreciation. While income provides steady cash flow over the life of the investment, capital appreciation is where the big gains can be earned.
During the pre-purchase due diligence phase of the transaction, it is the real estate investor’s job to estimate both the purchase price and the property’s “terminal value” or sales price. The difference between these two values represents the property’s price appreciation and these assumptions can have a dramatic impact on the projected returns.
But, in order to understand what these assumptions are and why they matter, it is first necessary to review the proforma creation process. In this article, FNRP explains what is a proforma, what is a capitalization rate, or cap rate, and how to define and calculate the entry cap rate and exit cap rate.
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What is a Proforma?
A proforma is a financial projection of a property’s future cash flows. Proforma inputs are based on the property’s historical performance and a set of assumptions about what will happen in the future. Generally, the proforma can be broken down into three sections:
- income,
- operating expenses, and
- debt service.
Rental income is derived from the property’s existing rent roll and an assumption about rent growth in the future. Inputs for this assumption include projections about renewal rates for expiring leases and growth in market rental rates over the same time period.
Operating expenses include things like property insurance, taxes, maintenance, and property management. These costs are also estimated based on historical performance and a series of assumptions about how quickly they will grow in the future. Income less operating expenses provides Net Operating Income (NOI), one of the necessary inputs into the cap rate calculation.
In the third section, a property’s debt service and loan balance are estimated by calculating the required loan payments and how much they reduce the principal balance over time. When complete, a proforma may look something like the table below:
A proforma is usually created using Microsoft Excel or a similar spreadsheet program. But, once it is completed the proforma provides part of the information necessary to estimate the entry and exit cap rates.
What is a Cap Rate?
A cap rate (or capitalization rate) is a before tax metric that represents an investor’s expected return on investment assuming an all cash purchase. The formula used to calculate the cap rate is Net Operating Income divided by property value. But, if the property value is unknown, the formula can be rearranged as NOI divided by the cap rate to get it.
Unlike residential properties, commercial properties are valued based on the amount of Net Operating Income they produce. As we discussed above, NOI is calculated as gross income minus operating expenses. When a “cap rate” is applied to NOI, a value can be estimated.
Cap rates in commercial real estate vary by property type and local market conditions. For example, the cap rate on a class A multifamily property in New York is likely to be far different than the cap rate for an office building in Tulsa. And, grocery-anchored shopping center cap rates may vary depending on the grocery store present.
What is an Entry Cap Rate?
The entry cap rate is simply the cap rate at the time of purchase. The entry cap rate is calculated based on the property’s purchase price and the year 1 Net Operating Income. Entry cap rates should be consistent with the cap rates for comparable properties in the same market.
For example, assume that the property in the proforma above has an asking price of $6,500,000. Based on year 1 Net Operating Income of $398,000, the implied entry cap rate is 6.12%. This should be consistent with the average cap rate for recent sales of similar properties in the same market.
What is an Exit Cap Rate?
The exit cap rate, sometimes called the terminal cap rate, is applied to the property’s final year of Net Operating Income to calculate the terminal valuation or sales price. As a best practice, exit cap rates should be conservative estimates that are slightly higher than the entry cap rates.
In general, the proforma for a commercial investment property usually assumes that Net Operating Income grows steadily over time. This could be due to rising market rents, expense reduction programs, or both. Over a 5-10 year investment holding period, the increase in NOI can be significant. To calculate the sales price, an analyst must make an assumption about what cap rate to apply to the property’s final year of Net Operating Income.
The entry cap rate provides a helpful reference point for this task, but the truth is that it is difficult to make an assumption about what similar properties will trade for 5 or 10 years into the future. We have always found that it is best to be conservative when making this assumption. If the exit cap rate is lower than the entry cap rate, the combination of increasing NOI and a lower cap rate will result in a substantial increase in property value. We always advise investors to be wary of this practice.
We have found that the best practice is to assume that cap rates rise slightly over the course of the investment holding period. For example, if the entry cap rate is 6.12%, the exit cap rate could be estimated at 6.5% or 6.75%. When applied to the final year of Net Operating Income, the sales price can be determined.
In the Proforma above, the final year of Net Operating Income is $479,000. If a cap rate of 6.5% is applied, this implies a sales price of $7.36M.
Because this “terminal value” is just an estimate and it is many years into the future, it can also be helpful to consider a range of cap rates and to calculate the returns based on each. For example, the following table calculates the terminal value based on a range of cap rates:
By estimating the sales price over a range of cap rates, the investor can back into the market value required to achieve their needed returns.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our real estate investing opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
