Capitalization rate lacks details

An office building in Tigard, Oregon demonstrates that capitalization rates are insufficient to determine market value.

April 29, 2016

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He also serves as  Vice President in Capital Markets at Silvergate Bankand holds the Chartered Financial Analyst (CFA) credential.

 Our client, a regional community bank located in Oregon, was experiencing a market anomaly. The bank could not reconcile between  between a $6.2 ,million purchase price and $9.7 million market value.The bank’s borrower was in escrow to purchase a building at a price that was almost 40 percent less than market value. 

We couldn't either.

Researching the office market in Tigard, we found five comparable properties.

sale comparable including capitalization rates
Table a: Sales comparables

You can observe the following: (1) the average and median price PSF are $155.78 and $171.74, respectively, (2) average NOI PSF average and median are $10.83 and $11.16, respectively, and (3) a 7.0 percent capitalization rate.

So if (1) thru (3) are correct, shouldn’t Subject Property, a 68,000 SF office building that generates an NOI of $680,000 , market value be greater than $7.4 million? 

The regional bank estimated the property market value was $9.7 million. “Even with a 15 percent variance in value, somewhere between $8.2 million and $11.15 million, I could live with. But a $6.2 million valuation?” the loan officer said.   

We analysed information from various resources. We reviewed financial statements;  spoke with local real estate professionals;  researched capital markets and public databases; and interviewed the borrower. 

We learned that the price discrepancy was the result of (1) below-market leasing rates, (2) dire mismanagement of operations, and (3) a rich capital expenditure strategy.      

First, below-market leasing rates: we found the average comparable lease rate at Tigard office market was $19.70; it was clear that Subject Property average lease rate of $13.60 was below-market.

rent comparables including dates and square footage
Table b: Rent comparables

Second, mismanagement of operations: a Life insurance company owned the property. Headquartered in the Charlotte, the company  said it was the only property ouside of their market. In addition, the operating expenses were running at 60 percent of gross income. A ratio inexcusable for any office-building operator

Third, a dear capital expenditure strategy: the bank’s client planned to invest over $2.0 million in capital expenditures. Once finished, they planned to market the property as an “open space”, typically associated with start-up companies.

Taking into account the three variables, the property could generate an NOI of $650,000, bringing it to a market value of $9.3 million.

But to reach that potential, the borrower needed to replace tenants, to improve  operations efficiency, and to invest capital for a total cost of $3.0 million. And hence, the discrepancy not seen via the capitalization rate.   

More often than not, capitalization rates do not reconcile with market value. We hope you see an illustration why that can be the case.