CAP rates and mobile home parks

[Jim Johnson]

As I ponder writing about this I am sure it will stir up some discussion. Good and intelligent investors will disagree on this point and though no real right or wrong will come of it... I choose to post.

As I make offers on more and more mobile home parks I find if somewhat difficult to discern that CAP rates. It seems some park owners, or maybe their agents, use the rental income to determine the cap rate for the park. I think to illustrate my point I will draw a example we can all follow...
100 space park with 50 rental homes- for this example lets say the park is full
space rent is $200 per month- for 50 homes = $10,000
rental income $500 per home- for 50 homes = $25,000
expenses for running the park are $7,500 per month (includes management fee)
repairs and maintenance (rentals) = $6,250 per month
So the numbers are:
$35,000 income
$13,750 expense

$21,250 net operating income

so on a 10 cap this park is worth $2,550,000

___________________________________
Now for the problem... lets say we break down these numbers a bit and see what we are getting for our money...
The income from the 'park only' sits at 100 spaces x $200 = $20,000
less the expenses to operate the park at $7,500
net operating income of $12,500 on a 10 cap is $1,500,000

the rest of the money- the delta between $1,500,000 and $2,550,000 is the value that is placed on keeping the mobile homes... it is their actual value if owned by the park... or in hard numbers...
$21,000 each.
Lets just say each of these homes in this rental park are 1980 3 bed 2 bath single wides... I can buy one of these even in the Denver market for $3,000 tops, move it for another $2,500... that is $5,500... now why would I pay almost 4 times that amount if they were park owned homes... see a cap rate multiplies net income yearly by 10...

So I open the discussion here... should rental income on mobile homes be included in the cap rate of the overall purchase price of the park?
My bias says no... but other investors that buy and flip parks say yes...
what say you... and why?

[Tim]

Jim,

I don't buy mobile home parks but I know someone who does and I will pose this question to them.

But...

The capitalization rate is just a shorthand method to deal with discounted cash flows of an asset. It has some basic assumptions built in, the most important of which in this case is the assumption of a homogeneous asset.

Those agents and owners are actually valuing a business in aggregate, not just the physical assets.

I suspect the difference is "in there" somewhere but like I said, I have never done a park so I will ask Herman the question.

[alexmorrow]

Can you explain cap rate in a little more detail Jim? For example, in your previous problem, let's say the park has a cap rate of 5 and the net operating income (noi) is $21,250. Does that mean that the park is worth $1,062,500? I got $1,062,500 by multiplying $21,250 times 50 (cap rate of 5 times 10). I really want to make sure I get the math right.

[Jim Johnson]

Can you explain cap rate in a little more detail Jim? For example, in your previous problem, let's say the park has a cap rate of 5 and the net operating income (noi) is $21,250. Does that mean that the park is worth $1,062,500? I got $1,062,500 by multiplying $21,250 times 50 (cap rate of 5 times 10). I really want to make sure I get the math right.
This says it so much better than I ever could... To be fair... I use CAP rates in general but really look at IIR- the internal rate of return as my best guide. It brings in depreciation, principal reduction and tax benefits.

Capitalization rate
From Wikipedia, the free encyclopedia


A capitalization rate (or "cap rate") is a measure of the ratio between the cash flow produced by an asset (usually real estate) and its capital cost (the original price paid to own the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:

* annual cash flow / cost (or value) = Capitalization Rate

For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net cash flow (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

* $100,000 / $1,000,000 = 0.10 = 10%

The asset's capitalization rate is ten percent.

Capitalization rates are an indirect measure of how fast an investment will pay for itself in net cash flows; each year, the percentage amount of the cap rate will be repaid. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years. Note that in real estate appraisal in the U.S., a stylized measure of cash flow is often used, called net operating income. It is essentially the same as net cash flow, except that debt service and income taxes are not included while a reserve for replacements is included. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from income to determine cost, value or required annual income.

Use for valuation

In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula above:

* Capital Cost (asset price) = Cash flow / Capitalization Rate

For example, in valuing the projected sale price of an apartment building that produces an annual net cash flow of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857.

This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal.

One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which only compares what other similar properties have sold for based on a comparison of physical characteristics). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income properties, are usually compared to ensure that estimated revenue is being properly valued.

Cash flow defined

The capitalization rate is calculated using a measure of cash flow called net operating income (NOI), not net income. Generally, NOI is defined as income (earnings) before depreciation and interest expenses:

* Cash flow = Net income + depreciation + interest expense + profit tax - reserves for repairs = Gross income - non-interest expenses

Interest expenses are excluded so that the valuation of the property does not depend on the amount of debt used to purchase the property; in financial terms, the cap rate is an unlevered valuation measure. Similarly, profit taxes (or other similar taxes) are usually excluded, as they will depend on the interest and depreciation expenses charged; most other taxes, and specifically property taxes, are treated as part of non-interest expenses.

Depreciation in the tax and accounting sense is excluded from the valuation of the asset, as it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition, however, estimated annual maintenance expenses or capital expenditures will be included in the non-interest expenses.

Although cash flow is the generally-accepted figure used for calculating cap rates, this is often referred to under various terms, including simply income.

Use for comparison

Capitalization rates, or cap rates, provide a tool for investors to use for roughly valuing a property based on its income. For example, if a real estate investment provides $160,000 a year in cash flow and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% equals $2,000,000.

Reversionary

Property values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements. In addition, a valuer also provides an Estimated Rental Value (ERV). The ERV states the valuer’s opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation.

The difference between the in-place rent and the ERV is the reversionary value of the property. For example, with passing rent of $160,000, and an ERV of $200,000, the property is $40,000 reversionary. Holding the valuers cap rate constant at 8%, we could consider the property as having a current value of $2,000,000 based on passing rent, or $2,500,000 based on ERV.

Finally, if the passing rent payable on a property is equivalent to its ERV, it is said to be "Rack Rented".

Change in asset value

The cap rate only recognizes the cash flow a real estate investment produces and not the change in value of the property.

To get the unlevered rate of return on an investment the real estate investor adds (or subtracts) the price change percentage from the cap rate. For example, a property delivering an 8% capitalization, or cap rate, that increases in value by 2% delivers a 10% overall rate of return. The actual realised rate of return will depend on the amount of borrowed funds, or leverage, used to purchase the asset.

In Europe, the term Yield is more frequently used in connection with real estate than capitalization rate. Yield is a more general term that refers to income in relation to the price of an asset.

Recent trends

A Wall Street Journal report using data from Real Capital Analytics and Federal Reserve [1] shows that since the beginning of 2001 to end of 2007, the cap rate for offices and apartments have dropped from about 10% to 5.5%, and from about 8.5% to 6% respectively. By comparison 10 year treasury yields has remained around 5% (except for a dip below 4% in 2003). Thus suggests that the investors now relying more on appreciation.

The National Council of Real Estate Investment Fiduciaries in a Sept 30, 2007 report reported that for the past year, for all properties income return was 5.7% and the appreciation return was 11.1% .

[Tim]

Jim, I asked Herman Dillard to look at your post and I have his permission to post this here. I am going to apologize in advance for him using the word "trailer" I can assure you he does not mean it in a disparaging way.

With parks you have to separate out the trailers unless the income from them is so small to not skew the value. When I look at a park I look at the income and expenses of the park assuming I will own none of the trailers. Then I look at what it would cost me to replace the trailers in the deal. The cost to buy, move, attach the plumbing and electrical, tie it down, all of that. Then I am willing to go about 25% over that to not have the pain in the @#$ of actually doing that. Then I total it up and that is my starting point. Agents and brokers will push to include the trailers in the income numbers because it skews things so much in their favor. If they insist I use the same logic Jim used in comparing the values.

[Jim Johnson]

Jim, I asked Herman Dillard to look at your post and I have his permission to post this here. I am going to apologize in advance for him using the word "trailer" I can assure you he does not mean it in a disparaging way.

I certainly feel the same way Herman does. Thanks for taking the time to have your friend look at the post.

To set the record straight, I am not offended by the term 'trailer' unless I perceive its use in a condescending way. That said... my perceptions are just mine and I can not really know intent... as I am reminded by my wife from time to time when we miss each others point... or I miss her point...

[rglidewell]

Jim,
It is my belief that land is real property and the mobile home is personal property. Much like a car, the mobile home as personal property is a depreciating asset and has a shorter economic life than standard stick-built homes. The land, with its associated pad rent, is determined to have a net operating income (NOI) using the expenses attributable to the mobile home pads. This would have a capitalization rate separate from the mobile homes.

A separate capitalization rate should be determined for the mobile homes based on the unit rents within the park and the aggregate unit values. (typically an average aggregate unit value based upon the age and condition, overall, of the mobile home units). The minimum monthly rent would typically be limited to the "capitalization cost recovery" over say, an economic life of 15 to 20 years, in addition to, any anticipated entrepreneurial incentive for purchasing the mobile home.

Because of the increased risk of owing a depreciating asset, theory would hold that the capitalization rate on the personal property mobile homes would be significantly higher than that of the mobile home pads, or rather the mobile home park. Althouh a blended rate may be determined, for simplicity, upon analysis of the two separate entities for an individual property, in my opinion, the blended rates are not comparable to each other. The personal property cap rates will vary greatly based on age, condition, and the expenses required.