Question

In: Finance

Reconstructed Operating Statement Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year...

Reconstructed Operating Statement Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Potential Gross Rent $457,200.00 $466,572.60 $476,137.34 $485,898.15 $495,859.07 $506,024.18 $516,397.67 $526,983.82
Allowance for Vacancies: Less $27,432.00 $27,432.00 $27,432.00 $27,432.00 $27,432.00 $27,432.00 $27,432.00 $27,432.00
Other Income $34,000.00 $34,697.00 $35,408.29 $36,134.16 $36,874.91 $37,630.84 $38,402.28 $39,189.52
Effective Gross Income $463,768.00 $473,837.60 $484,113.63 $494,600.31 $505,301.97 $516,223.02 $527,367.95 $538,741.35
Less: Less: Less: Less: Less: Less: Less: Less:
Property Tax $85,039.00 $85,039.00 $85,039.00 $93,543.00 $93,543.00 $93,543.00 $93,543.00 $102,897.00
Other Income (Super expense plus free rent expense) $49,240.00 $50,249.42 $51,279.53 $52,330.76 $53,403.54 $54,498.32 $55,615.53 $56,755.65
Insurance $13,300.00 $13,572.65 $13,850.89 $14,134.83 $14,424.60 $14,720.30 $15,022.07 $15,330.02
Workers Compensation $145.00 $147.97 $151.01 $154.10 $157.26 $160.48 $163.77 $167.13
Utilities $1,140.00 $1,163.37 $1,187.22 $1,211.56 $1,236.39 $1,261.74 $1,287.61 $1,314.00
Supplies and Miscellaneous Expenses $1,391.30 $1,419.83 $1,448.93 $1,478.64 $1,508.95 $1,539.88 $1,571.45 $1,603.66
Professional Property Management Fees $27,826.08 $27,826.08 $27,826.08 $27,826.08 $27,826.08 $27,826.08 $27,826.08 $27,826.08
Landscaping and Snow Removal $2,500.00 $2,551.25 $2,603.55 $2,656.92 $2,711.39 $2,766.97 $2,823.70 $2,881.58
Maintenance Staff $12,000.00 $12,246.00 $12,497.04 $12,753.23 $13,014.67 $13,281.47 $13,553.74 $13,831.60
Total Operating Expenses $192,581.38 $194,215.57 $195,883.25 $206,089.13 $207,825.89 $209,598.25 $211,406.95 $222,606.73
Annual Net Operating Income $271,186.62 $279,622.03 $288,230.37 $288,511.19 $297,476.09 $306,624.77 $315,961.00 $316,134.62
Capitalization Rate 8.34% 8.60% 8.87% 8.88% 9.15% 9.43% 9.72% 9.73%
Market Rate Value $3,250,000.00

Question 1

A) Suggest some reasons why the market capitalization rate might NOT remain constant.

B) Why might it become larger or smaller than the currently prevailing market rate?

Solutions

Expert Solution

A. The capitalization rate is obtained by dividing the net operating income by the market value of the asset. So, in this case, the market capitalization rate may be obtained as follows:

Year 1: Annual net operating income/Market rate value = $ 271186.62/ $3250000= 8.34%

Year 2: Annual net operating income/Market value = $ 279622.03/ $3250000= 8.60%

Year 3: Annual net operating income/Market value = $ 288230.37/ $3250000= 8.87%

The capitalization rate may not remain constant due to changes in market prices of the asset (such as real estate), or due to any changes in operating income, examples being changes in inventory, shipping and storage costs, etc.

Some of the reasons why the capitalization rates may vary could be due to the following:

Lack of accounting for replacement reserves:

In case of real estate, replacement reserves may or may not be part of the NOI or the net operating incomes. Replacement reserves refer to sums set aside for periodic replacement of building components, that need to be replaced or changed from time to time.

Some real estate professionals may include the same in order to boost their net operating income and improve the valuation of the property.

Property management fees:

Some owner managed properties or business entities may not report property management fees as part of the proforma. Usually having an asset managed by a professional reduces the risk profile and therefore has a lower cap rate.

Volatility in market prices of assets:

Asset prices such as that of real estate may fluctuate in the market, on a frequent or periodic basis, which may cause variations in the capitalization rates.

B) As we saw, the capitalization rate may not remain constant due to changes in market prices of the asset, or due to any changes in operating income.

For example, an asset proforma that does not provide for adequate reserves will have lower-than-market expenses on a per unit basis, than the one who sets aside reserves and provisions for capital expenditures. An asset proforma without provisions may have a riskier profile than other assets of a similar nature.

Depending upon the nature of assets, levels of risk, and operational costs, one can have cap rates that are higher or lower than prevailing market rates.

Sources:

With inputs from credible digital and print sources   


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