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Hi Spencer,
I’m having a hard time understanding the use of cap rates and valuations from a real-world perspective.
In the video in lecture 2.5, we calculated the cap rate to be 6.57%, using the underwritten NOI, and the “whisper price” of $55M. So this cap rate rate of 6.57% (which correct me if I’m wrong, I view as the yield % on an investment) is higher than the comp set average cap rate, tells us that this investment is feasible for our company looking to make an offer?
Subsequently in the video, you say 6.57% is a little high, and you bring it down to 6.5%, which brings our valuation up to $55.55M. In reality, do we have the flexibility of adjusting our own cap rates? Is it possible that our investors/lenders can demand or require that we hit a certain cap rate on acquisitions? And lastly, by adjusting the cap rate down to 6.5%, we brought our valuation over the whisper price, and if, for example, this deal offering did not include a whisper price, and we made an offer of $55.55M when the seller would have been happy with an offer of just $55M, wouldn’t we be overpaying by $0.55M because we lowered our cap rate?
I apologize if I am overloading with questions, but I don’t have much experience with cap rates. I am totally enjoying the courses and loving the modelling so far!
Thanks
Hi,
Some great questions and I can understand the confusion with cap rates. Let me see if I can answer your questions, while sticking to the practical (and avoiding the theoretical).
In the real world, cap rates are used by buyers, sellers, developers, and owners to value real estate and make real estate investment decisions. So when a willing buyer and a willing seller agree on a cap rate and NOI, a transaction occurs. When buyers and sellers don’t agree, we call this a bid-ask gap and when it occurs on a macro-level it leads to reduced transaction volume (i.e. reduced liquidity) – note that this phenomenon is currently going on in the United States (click here for an interesting read on the subject).
My example in 2.5 is a scenario where there is no bid-ask gap. In fact, the buyer (us) is likely willing to pay more than what the seller is expecting. Thus the “whisper price”, which is essentially what the seller is expecting to get on the sale, is lower than what we as a buyer would be willing to pay.
Now keep in mind, this is not atypical in commercial real estate. Generally speaking, commercial real estate sales in the United States are managed through a bid process. The broker representing the seller first shares the opportunity with a pool of buyers (either publicly or privately) and gives a timeline for when first round bids are due. Buyers then perform their first round analysis and due diligence and submit bids on or before the due date (read Michael’s blog post on letters of intent).
And while the seller may have a price in mind, because buyers are competing with one another the buyers may offer more than what the seller is expecting in order to win the deal. They may also offer less of course, which is the bid-ask gap I mentioned above. And when there’s a bid-ask gap, often the seller will not accept any of the bids deeming it better to hold rather than sell at that price – this will make more sense once you complete the hold/sell analysis exercise in course 3.
In the case of Crescent Apartments from lecture 2.5, we believed that a 6.5% cap rate was appropriate. And just as importantly, we knew at 6.5% the seller would likely transact. Now 6.5% may not win the deal. There may be a buyer who gets comfortable with either a higher net operating income and/or lower cap rate, but at least at 6.5% we know it’s a deal worth spending time on.
That was a lot to digest, so feel free to ask follow-up questions if something is not entirely clear.
Spencer
Thank you very much Spencer, that really cleared things up. My confusion was really because I was somehow neglecting that in reality, there is a bidding process, and sometimes you want to lower your cap rate a little, to be a little more aggressive on the bid.
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