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Deep Dive: The Proforma Income Capitalization Valuation Method & the Commercial Real Estate Cap Rate

Updated: Aug 24

In the vast world of commercial real estate valuation, the Income Capitalization Approach plays a pivotal role. Particularly for small income-producing assets, its significance is unparalleled, yet it scales seamlessly to larger properties. But like all tools, mastering its intricacies is crucial to its effective application. Here's a breakdown, starting with a couple of exceptions to the rule and then condinuing with calculating NOI for direct capitalization.

This is a typical proforma analysis which includes NNN reimbursements.
Typical Income Capitalization Proforma

Complex Lease Structures Will Need More than a Cap Rate Analysis.

When dealing with properties that have multiple leaseholds, each having varied terms and expiration dates, a simple cap rate might not tell the complete tale. A meticulous lease-by-lease analysis is indispensable in such cases to capture the property's true value dynamics.

Net Leased Assets: A Different Proforma Method

Typically, net-leased assets are a hands-off investment. Tenants shoulder the brunt of expenses, leaving landlords with minimal financial responsibilities. Market participants often bypass expenses in these cases, given their direct payment nature.

The Art of Calculating Proforma Net Operating Income (NOI)

In most cases, however, the journey to an accurate NOI is still often riddled with inconsistencies. Despite numerous nuances, there's a consensus among renowned national brokerage firms and appraisers on how it should be done:

  1. Revenue - Effective Gross Income: The benchmark is always the market rent, irrespective of the property's actual rent. Any deviations from the market standard - be it above or below - are adjusted accordingly. The same principle applies to expense recoveries; they're based on projected, not actual, expenses.

  2. Vacancy and Collection Losses: Estimating these is more art than science. Factors like economic fluctuations and unforeseen circumstances like the Covid pandemic can swiftly change vacancy rates. The trick is to focus on long-term trends rather than being swayed by transient changes.

  3. Operating Expenses: When estimating expenses, the market standard remains the gold standard. This extends from taxes, which are based on post-sale reassessments, to insurance costs, which should reflect current market rates, not the actual expense. Exceptional costs, especially in areas like management fees pumped up as high as 10% by landlords capitalizing on their reimbursement, are disregarded in favor of obtainable market averages, typically hovering between 3% and 5%.

  4. Reserves: These are occasional long-term costs a landlord will incur over a 25-year span, like necessary repairs and roof replacements. They're often overlooked since they occur rarely and only necessary when they suddenly are. However, estimating a sinking fund for them based on surveys or paid-for property-specic studies is essential to ensure the property's long-term financial health.

After NOI and Income Capitalization

In the world of property valuation, it's the details like those above that can sometimes make the most significant difference. Even the smallest of nuances can lead to substantial discrepancies in valuation, particularly when it comes to calculating the Net Operating Income (NOI) of a property. Here, we delve into two critical aspects to watch out for: deviations in rent and "extraordinary" non-recurring costs.

Above or Below-Market Proforma Rent Adjustments

Rental income is a fundamental component of a property's value. But what happens when a property is rented out at a rate that's significantly higher or lower than the prevailing market rate? This can skew the property's perceived value. To correct this:

  1. Identify the Deviation: Start by determining the discrepancy between the current rental income and the prevailing market rent based on the latest leases at the property and comparables.

  2. Estimate the Impact: For a property with a below-market lease, consider the lease's remaining duration. If the lease has a year or more left, calculate the present value of the below-market rent over this period.

  3. Adjust the NOI: Once you've determined the positive or negative value of the rent deviation, deduct (for below-market rents) or add (for above-market rents) this amount from the property's value based on market terms. This is what the property loses or gains for below market terms. Market value equals value at market rents plus or minus the gain or loss.

Factoring in Extraordinary Costs

Not all expenses linked to a property are regular. Some costs are extraordinary and non-recurring. These might include one-time renovation expenses, litigation costs, or any unexpected major repairs to be done in the short term. The deduction is intuitive - simply subtract the cost from the indicated market value.

While these costs do affect the property's finances in the short term, they don’t typically influence its long-term NOI. Therefore:

  1. Identify the Costs: Clearly outline and itemize each non-recurring expense related to the property.

  2. Analyze Impact: Determine the financial implication of each extraordinary cost on the property's NOI - will the replacement or repair improve NOI, perhaps through better energy efficiency?

  3. Adjust the Value: Deduct these one-time costs from the indicated value for an accurate representation of the property's value. So, if it needs a roof, deduct the roof expense. Be sure to also deduct an entrepreneurial incentive (or profit) for the landlord-friction.

Income Capitalization Summary

An accurate property valuation requires more than just a glance at its top-line numbers. Both above- or below-market rents and extraordinary costs play a crucial role in the valuation process. By analyzing these nuances as a side-bar, and subsequently adjusting the 'market' proforma, investors and property analysts can ensure a more precise and comprehensive property evaluation.

In Conclusion: Cap Rates & Proforma NOI

In the realm of commercial real estate, every investor must sharpen their tools and understanding. The Income Capitalization Valuation Method, with its myriad nuances, stands as a testament to this principle. By understanding and accurately applying its parameters, one can truly gauge the value and potential of a property and in some cases uncover hidden risks or upside.

As we have illustrated, the Cap Rate and how Proforma NOI are calculated are interrelated in the Income Capitalization Valuation Approach.

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