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REAL ESTATE Cap rate questions

Sid23

Bronze Contributor
Aug 9, 2007
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I was working through some of the MIT material and came across these questions. I think I know the answers, but wanted to double check. Here are the questions...What do you think are the answers? Reasons why? I thought this may be a good exercise for all.

"Other things being equal, which would have the LOWER cap rate, property A or B?

1) A - An apartment building in a declining neighborhood

B - An apartment building in a growing neighborhood

2) A - An office building full of long-term tenants

B - An office building full of short-term tenants

3) A - Real estate when LT bonds yield 6% (with 3% inflation)

B - Real estate when LT bonds yield 8% (with 3% inflation)

4) A - A surface parking lot in a thriving downtown.

B - A 10-story parking garage in a thriving downtown.

5) A - An office bldg with short-term below mkt leases in a growing rental market

B - An office bldg with short-term above mkt leases in a declining rental market.
 

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bflbob

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Jul 25, 2007
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I was working through some of the MIT material and came across these questions. I think I know the answers, but wanted to double check. Here are the questions...What do you think are the answers? Reasons why? I thought this may be a good exercise for all.

"Other things being equal, which would have the LOWER cap rate, property A or B?

1) A - An apartment building in a declining neighborhood

B - An apartment building in a growing neighborhood

2) A - An office building full of long-term tenants

B - An office building full of short-term tenants

3) A - Real estate when LT bonds yield 6% (with 3% inflation)

B - Real estate when LT bonds yield 8% (with 3% inflation)

4) A - A surface parking lot in a thriving downtown.

B - A 10-story parking garage in a thriving downtown.

5) A - An office bldg with short-term below mkt leases in a growing rental market

B - An office bldg with short-term above mkt leases in a declining rental market.
1. "B" assuming the decline has been realized, and not that the market has just peaked and reversed. Generarally you would be paid more in a growing neighborhood than a declining one, and the higher the price in comparison to a similar property with a similar NOI, the lower the CAP rate.

2. "A", since it represents less risk.

3. "A", since the reward from real estate is higher in comparison to the alternative.

4. This one is tough. I'd say neither would justify a lower CAP rate than the other since the risks and rewards would be similar. Obviously the price for the 10-story would be higher, and it might carry a slightly lower CAP rate due to efficiencies of scale.

5. "A" for sure. The opportunity to increase rents is just around the corner, and the demand is there. If the NOI were the same on both, "A" would certainly demand a higher price.

Did I do OK?:banana:
 
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Sid23

Bronze Contributor
Aug 9, 2007
683
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Wouldn't a higher cap rate be less risky than a lower one? Bob, you said a lower one is less risky.

$8,000 NOI / $100,000 price = 8% cap

$1,000 NOI / $100,000 price = 1% cap

Wouldn't the 8% deal be less risky?
 

bflbob

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Wouldn't a higher cap rate be less risky than a lower one? Bob, you said a lower one is less risky.

$8,000 NOI / $100,000 price = 8% cap

$1,000 NOI / $100,000 price = 1% cap

Wouldn't the 8% deal be less risky?

Nope...

Why would you pay 100 times earnings (NOI) to buy the second property if you felt the first was less risky? An 8% CAP is equal to 12.5 times earnings.

I think you are mixing up risk with reward.

Think of it this way...you have two rental properties available to buy. Both will give you a $10,000 NOI.

Property "A" is in a nice neighborhood. Crime is low. Employment is good. Tenants stay for years and pay on time.

Property "B" is in a war zone. The existing landlord is selling because he can't walk since he got shot collecting rents. Tenant turnover is high, and collecting is downright dangerous.

Your NOI is the same on both...$10,000. Which would you pay more for?

In practical terms, you might pay $200,000 for property "A", which will result in a 5% CAP. You risk is minimal, so you'll pay more to get it.

But for property "B", if you bought at all, you would likely only offer around $50,000-$67,000. This results in a 15-20% CAP. Your risk is higher, so you'll pay less.

Your reward on property "B" (20%) is four times higher than on property "A" (5%), but your risks are likely four times higher too.
 

SteveO

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"Other things being equal, which would have the LOWER cap rate, property A or B?
1) A - An apartment building in a declining neighborhood

B - An apartment building in a growing neighborhood
Some assumptions need to be made here. By declining and growing, do you mean rents and occupancy?

Most apartment buildings and locations are going to go through ups and downs. I think of these in terms of a sine wave. There may be long ups and downs. The cap rate in theory would be lowest during the latter part of the incline and the first portion of the decline.

2) A - An office building full of long-term tenants

B - An office building full of short-term tenants
Not enough information. If the short term tenants are below market rents, then "B" is the correct answer. If the short term tenants are at or close to market, the answer is "A".

3) A - Real estate when LT bonds yield 6% (with 3% inflation)

B - Real estate when LT bonds yield 8% (with 3% inflation)
"A" as Bob stated.

4) A - A surface parking lot in a thriving downtown.

B - A 10-story parking garage in a thriving downtown.
I'm going with "A". The land value would likely be the driver more than the cap rate. Thus the lower income would be the lower cap.

5) A - An office bldg with short-term below mkt leases in a growing rental market

B - An office bldg with short-term above mkt leases in a declining rental market.
"A" if the investor understands the market.
 
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Sid23

Bronze Contributor
Aug 9, 2007
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Thanks for the discussion / corrections.
 

Yankees338

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Jul 24, 2007
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I was working through some of the MIT material and came across these questions. I think I know the answers, but wanted to double check. Here are the questions...What do you think are the answers? Reasons why? I thought this may be a good exercise for all.

"Other things being equal, which would have the LOWER cap rate, property A or B?

1) A - An apartment building in a declining neighborhood

B - An apartment building in a growing neighborhood

2) A - An office building full of long-term tenants

B - An office building full of short-term tenants

3) A - Real estate when LT bonds yield 6% (with 3% inflation)

B - Real estate when LT bonds yield 8% (with 3% inflation)

4) A - A surface parking lot in a thriving downtown.

B - A 10-story parking garage in a thriving downtown.

5) A - An office bldg with short-term below mkt leases in a growing rental market

B - An office bldg with short-term above mkt leases in a declining rental market.
I'm sure I'm incorrect on most of these, but here's what I would have said and my explanations for doing so.

1) By a "growing" neighborhood, I would assume it means it's at the top of its cycle. Therefore, the property values should be at their peak, resulting in a lower cap rate for scenario "A".

2) To me, it depends on where the rents are in relation to market rents and what type of market it is in. If the rents are about even with market value and the area is growing, it would be "B". If the market is declining, it would be "B". If rents are below market and the market is growing, definitely "B". Really depends on the situation for this one.

3) "A" for reasons stated by Bob.

4) I'd probably say "A", but it depends on the situation. Economies of scale could shift it towards "B", but it depends on the situation.

5) I would certainly rather have "A", but I think "B" would assess for a higher value.


Very good exercise. I hope we can get more of these going. Maybe we could even get an area created on the board devoted strictly to activities such as this for education. Again, thanks a lot for contributing. Speed +++
 
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