Delving Into the Capitalization Rate

Why have cap rates declined precipitously over the last 6 years? Why do cap rates decline at
all? What factors create a declining cap rate? If you are an investor then by definition you
should be intensely interested in the future of your investments. It is therefore imperative for
any real estate investor to understand the most consistently used ratio to value commercial
real estate.

The definition of the cap rate, shown below, seems simple enough, but the complex factors
that influence this little ratio are buried beneath the surface.

Cap Rate =    Net Operating Income  
                        Property Value

Put simply there are three influencing factors of the capitalization rate which I will break
down one at a time.

1. Cash Flow
2. Risk
3. Speculation

1. Cash Flow

Property values historically increase at the same pace as rent growth. If rents and values
really do move in tandem over time then why would the cap rate change at all? Part of the
reason lays in the fact that cap rates are almost always reported using trailing twelve month
NOI but property values always reflect the expected future earnings that an investor hopes to
collect. Therefore the numerator in the equation is backwards looking while the denominator
is forwards looking creating a fundamental disconnect at the time of sale.


Cap Rate=   Trailing Twelve Month NOI      <--  Backwards Looking
                            Property Value                 <--  Forwards Looking


Although historical NOI is a helpful indicator in determining future NOI it is only an
indicator and is never what the investor focuses on when valuing a property. It should,
therefore not be included in an equation used to value a property. However if we can change
the equation so that it represents how an investor looks at the property by using the expected
future earnings that an investor hopes to capture, then the equation would be in alignment
and would look something like this:


Cap Rate=    Expected NOI Over Life of Investment   <--Forward Looking
                            Property Value                             <--Forward Looking



In a world without speculation or changing risk preferences and with reliable data for
expected NOI in the numerator, then our graph would look something like this even if
earnings growth were expected to double.

2. Risk

Why doesn’t the cap rate change? The answer lies in the risk side of the equation. In this
perfect world we have created above, the only factor that would actually change the cap rate
would be if investors were willing to change how much they are willing to pay for the
expected cash flows of commercial real estate. This is why I emphasized changing risk
preferences above. In that perfect world we assume that only one risk preference exists and
that preference is set at a 9% cap rate.

If we rearrange the cap rate formula then these risk preferences become more apparent. If a
market has an 8% cap rate then it can be said that for every $1 in earnings an investor is
willing to pay $12.50 dollars (1/0.08) for the property. This 1 to 12.5 ratio represents the
investor’s risk appetite for commercial real estate cash flows. In this way we can write out
the cap rate equation as:

Risk Appetite (8%) = Earnings ($1)
                                  Value ($12.50)

If earnings increase exponentially, but the risk appetite remains the same then the nominal
value will increase accordingly as shown below.


Risk Appetite: 8% (No Change) =     ↑ Earnings: $2 (100% increase)    =      $1  
                                                         ↑ Value: $25 (100% increase)            $12.5

I include the $1/$12.5 at the end to remind you that no matter how much earnings increase
the ratio remains the same even though the nominal value of the property might have
increased dramatically. However, when investors do change their risk preferences change the
effect on property value can be dramatic.

↓ Risk Appetite: 10% (25% increase) =        Earnings: $1 (No Change)   
                                                                 ↑ Value: $10 (20% decrease)

To fully understand why investors change their risk preferences for real estate we must take a
10,000 foot perspective on the asset class of commercial real estate. In the last ten or so years
Wall Street has made great strides at making investing in commercial real estate as easy as
buying another stock on the exchange. Because real estate has become similar to stocks and
bonds then investors must look at the returns of all three asset classes before deciding where
to invest their money. If the cap rate represents the expected yield to investors in real estate
then it is comparable to yield measurements used in the other asset classes such as the
Price/Earnings ratio used for stocks and the bond coupon, which is the interest income
divided by the price paid for the bond. Each yield tells us how much an investor is willing
to pay for the expected cash flows of that asset class.

The reason why investors would change how much they are willing to pay for real estate cash
flows is because of a change in perceived risk of real estate versus the other asset classes. A
good example of this was the aftermath of the dot com crash when investors fled from stocks
and poured their money into real estate as it was perceived as a much safer and more stable
investment than the alternatives. Thus investors were willing to pay more for the cash
flows produced by commercial real estate assets thereby driving down the cap rate,
which is displayed graphically in the chart at the top.

3. Speculation

So far we have discussed how price reacts to cash flows, but what happens when price reacts
to price? The third and final factor affecting the cap rate is speculation defined as
“Engagement in risky business transactions on the chance of quick or considerable profit”
(Dictionary.com). Speculation in real estate means buying a property in the hopes of selling it
one day for a greater price than can be justified by any increase in the cash flows.
Speculation will always be prevalent in real estate and therefore must be considered as just as
major of a factor in breaking down the reasons for cap rate movements.

Speculation can significantly affect the property value portion of the equation so much so
that all other factors essentially become drowned out. Although it is difficult to determine
how much risk or speculation is contributing to a lower cap rate, it is helpful to compare the
annual cash returns investors are getting (the cap rate) versus other comparable asset classes
(such as the P/E ratio or the treasury yield) and then determine if the returns in real estate are
reasonable. If they are not reasonable then it is safe to assume that speculation has taken hold
of property values.

In a purely speculative environment the cap rate is no longer a meaningful
measurement because cash flow is not the driving factor of price determination.

Ulcer Index Calculation - Custom Function in Excel

If you are looking to find the Ulcer index of a return stream, best described here, then follow the steps below:

• Hit ALT + F11 to access the VBA editor
• Insert>New Module
• Copy and paste the code below into the module:

Function UlcerIndex(MyArray As Range)

'Copyright Mark Reichert 2011 mark_reichert@cox.net

Dim CurValue As Double
Dim MaxValue As Double
Dim MyCell As Range
Dim CurDD As Double
Dim MaxDD As Double
Dim CurDD_Sqrd As Double
Dim SumOfSqrs As Double
Dim NumOfDataPnts As Integer

MaxValue = 0
MaxDD = 0
CurValue = 1000
CurDD = 0
SumOfSqrs = 0
NumOfDataPnts = MyArray.Rows.Count

For Each MyCell In MyArray
       CurValue = CurValue * (1 + MyCell)
       If CurValue > MaxValue Then
       MaxValue = CurValue
       Else
       CurDD = (CurValue / MaxValue - 1)
           If CurDD < MaxDD Then
           MaxDD = CurDD
           End If
              
       End If
CurDD_Sqrd = CurDD ^ 2

SumOfSqrs = SumOfSqrs + CurDD_Sqrd


Next MyCell


UlcerIndex = (SumOfSqrs / NumOfDataPnts) ^ 0.5
   
End Function
  
End Function

• Hit Save, then ALT + F11 to get back to Excel
• In any excel cell type =UlcerIndex( and select the % returns you would like to calculate the Ulcer Index for.

Max Drawdown Calculation - Custom Function in Excel

Excel User Defined Function

If you are looking to find the max peak to trough drawdown on a return stream, then this is a great tool for you. To use simply follow the steps below:

• Hit ALT + F11 to access the VBA editor
• Insert>New Module
• Copy and paste the code below into the module:

Function MDD(MyArray As Range)

'Copyright Mark Reichert 2011 mark_reichert@cox.net

Dim CurValue As Double
Dim MaxValue As Double
Dim MyCell As Range
Dim CurDD As Double
Dim MaxDD As Double



MaxValue = 0
MaxDD = 0
CurValue = 1000

For Each MyCell In MyArray
       CurValue = CurValue * (1 + MyCell)
       If CurValue > MaxValue Then
       MaxValue = CurValue
       Else
       CurDD = (CurValue / MaxValue - 1)
           If CurDD < MaxDD Then
           MaxDD = CurDD
           End If
           
       End If
       

Next MyCell

MDD = MaxDD
   
End Function

• Hit Save, then ALT + F11 to get back to Excel
• In any excel cell type “=MDD(“ and select the % returns you would like to calculate a maximum drawdown for.

Do excess bank reserves really lead to inflation?

Do excess bank reserves really lead to inflation?
All the hoopla over bank reserves has led me to do some analysis on the matter and I have come to the conclusion that inflation may come at us, and come at us hard, but excess reserves will not be the culprit. Since about 95% of our money supply is in the form of credit, we must understand how credit is created before a valid conclusion can be drawn about whether an increase in bank reserves leads to inflation.
In school we are taught to believe that base money comes first and is multiplied out as credit money at a decreasing rate throughout the banking system. However, in 1979 an economic journal , the opposite was discovered₁. Banks extend credit first and then afterwards seek out reserves. As said succinctly by an economist, Bail Moore,"In the real world, banks extend credit, creating deposits in the process, and look for reserves later"₂. We live in a credit money dominated society (To the tune of $52 trillion) where banks create the money and the money supply is fluctuates based upon society's ability to service debt.
There are basically two types of restraints on bank lending:

1.       Reserve Restraints. By law, banks are required to hold a certain percentage of their transaction deposits in the form of reserves. In practice, a bank only holds enough reserves to cover settlements at the end of each day (i.e. depositor withdrawals) as there are many ways to get around the reserve requirements.

2.       Capital Constraints. Having enough equity to support additional lending activities (Think overall leverage ratio for the bank). Reserves are not equity, they are an asset of the bank.

Reserve Restraint

As stated before, although banks are required to hold a certain portion of their assets in the form of reserves, banks only hold enough reserves necessary to process settlements at the end of each day. This is because there are so many loopholes as to which accounts require reserves and at what time that it becomes a minor issue for the bank. However, there is always the very real need for the bank to hold a certain amount of short-term liquid assets in order to pay out depositor withdrawals and the like.
This need for liquid assets is met be a special, highly liquid market of bank reserves. Only banks are allowed to hold these instruments and the Federal Reserve is the sole supplier. The need for a bank to settle cash claims each day is met by this reserve market. Banks rely on trading amongst themselves to satisfy short term needs. A real problem can arise if banks aren't willing to trade reserves with each other as was the case in 2008 when distrust ran high amongst banks and they were only willing to lend at high interest rates and to a few participants. In situations such as these the banks really are constrained to lend because they fear they will not be able to meet depositor withdrawal demands and therefore might cease lending activities until the problem is resolved. In periods of extreme stress such as this, the Fed can step in and flood the market with reserves in order to allow banks to meet their cash needs. The influx of reserves can free up the overnight market, which in turn frees up lending.
Other than these types of periods, banks are never really reserve restrained as the Fed will always provide the amount of reserves that are demanded by the banking system. The reason for this is because the Fed's primary monetary policy tool is to set the FFR and it cannot do this if there is turmoil in the overnight market. This turmoil could result if there are insufficient reserves for settlement purposes as was mentioned previously. The reason for this is because the demand for bank reserves is inelastic as is shown in the diagram below:

  

This inelastic demand curve means that the bank absolutely requires that that a certain amount of reserves be available and if there is an insufficient supply then the overnight rate would spike up tremendously as bank's clamored for reserves.  Therefore the Fed first makes sure that all supply equals demand first, and then they target the fed funds rate, which allows them to achieve their target without the extreme volatility of supply shocks. The Fed targets the FFR because it directly influences the prime rate and other rates that are widely used as consumer credit benchmarks.

 
Are Reserves somehow special and unique?

The only thing really 'unique and special' about Reserves are the fact that the fed is the sole supplier and thus determines the market rate of interest, only banks can use reserves, and the fact that reserves are also often used as the market of last resort for short term financing needs. But that is where the uniqueness ends. Remember that reserves are considered to be a part of the bank's assets, not equity, and are therefore not able to make a bank solvent, if impaired. Reserves are actually very similar in nature to T-Bills, as they are both short term, highly liquid, and basically risk-free. Amounts in excess of the reserves are just another liquid asset of the bank. It is important to note that the fed still does impose a 10% reserve requirement on banks but there are so many loopholes, such as overnight sweeps of checking accounts, and no reserve requirement on corporate accounts, that the requirement is a mirage and reserve requirements do not really impose any sort of restraint on the bank. This is evident when you look at the total debt of the economy versus the base money supply ($52 trillion in debt versus $800 billion in reserves, far less than the 10% reserve requirement)

 

How we should perceive excess reserves:

The excess reserves in the banking system do not mean anything more than the Bank's choosing to hold more of their liquid assets in the form of bank reserves, instead of say, T-Bills. The increase of a banks liquid assets (reserves) does not make a bank any more capable of increasing lending than a construction of a new freeway would somehow increase the number of cars on the road. Just as the new freeway allows for more cars to be on the road, it is pointless if it is: (a) not needed and (b) there aren't any more drivers taking to the road. This is how we should think of excess reserves. They are not needed as the demand for settlements is already taken care of (inelastic demand curve) and there aren't an increasing number of qualified borrowers or increased asset values to lend against. This is strikingly evident when you look at the case of Japan in the last decade. The BOJ expanded reserves at an incredible rate but lending actually decreased during this time period.

 

1. "The Endogenous Money Stock", Journal of Post Keynesian Economics, 1979, Volume 2, pp. 49-70.
2.  Basil Moore 1983, "Unpacking the post Keynesian black box: bank lending and the money supply", Journal of Post Keynesian Economics 1983, Vol. 4 pp. 537-556; here Moore was quoting a Federal Reserve economist from a 1969 conference in which the endogeneity of the money supply was being debated.