Proving Band of Investment & Mortgage Equity Cap Rates are Obsolete – Part 1 of 2

Comments are closed
Posted by

In prior posts, I’ve outlined many of the weaknesses of each of these techniques.  What I find interesting is that the Band of Investment and Mortgage Equity techniques are still being used rampantly in the appraisal industry today.  This recession should have been a wake-up call that market derived cap rates are the way to go, yet it’s just so quick and easy to do one of these cap rate substitutes!  What good is technique that is not usable during down business cycles like recessions?

Reality at Ground Level

Let’s say you do a band of investment (BOA) or mortgage equity (ME) today.  The biggest problem is that you are saying that someone can get financing at a certain rate and certain terms.  ‘Seems obvious, right?  Try getting that financing.  You need a credit score that’s sky high and at least 20 percent down, if not up to 50 percent.  If a BOA or ME has this, what you’re really saying is that it is typical that only a very small percentage of the market can get this financing today.  In other words the exception to the rule.  Sounds like a “hypothetical assumption” as we appraisers say, right?

So let me run this by you.  You see adjustments in the sales comparison approach for financing terms.  That means that the analyst is supposed to be determining if the financing was at market.  How else can they make the adjustment?  Well, what were those financing terms?  If the analyst did his/her homework, you know what I know – that almost every sale has seller financing or is an all-cash sale.  If none of the sales have financing ratios from a lender anywhere near what is used in the BOA or ME, isn’t that a contradiction in terms?  ‘Sounds like an easy way to discredit the BOA or ME.  I’ll try to remember that when I’m called into court and the other guy didn’t use market derive cap rates.

Deal Flushing

There’s another way to know if there’s no money supply for lending.  Take a look through the multiple listing service at how many deals are back on the market because financing fell through.  There are more such deals now than ever.

That brings me to another roundabout point.  If financing were so prevalent, would there be so many listings on the market for every property type?  The inventory would have been reduced way lower than it is now.

Positive and Negative Leverage

I’ve blogged at length about positive and negative leverage.  With the exception of investment and near investment grade real estate, you can expect almost all commercial real estate to be in the positive leverage category today.  That means if you can finance the deal, your return on investment goes way up.  Since the definition of market value states “the buyer and seller each acting prudently and knowledgeably”, by extension you have to assume that all positive leverage deals would have to have financing, otherwise the return on investment would be handicapped.  Since the financing reality for the vast majority of commercial real estate is that it is not available, you’re saying that a purchaser is willing to accept a much lower return to buy the property.  Buyers today need double digit returns on investment to be interested and if that isn’t reflected in the BOA or ME, someone goofed.

Is that return comparable to any other source?  Let’s say the unleveraged return on investment (i.e. cash flow rate or equity dividend rate) were 7 percent.  That’s a lot better than multiple year U.S. bond rates, Treasury, Municipal or otherwise.  Have you looked at the bond rates in Australia or other countries?  You’ll find that that spread is hardly anything.  More importantly, given today’s credit crisis, poor consumer confidence levels and the downturn in sales since the recession began, that 30, 40 or 50 percent down payment is the cushion many buyers need just to keep their businesses alive, let alone acquire properties.  Survival first!

There’s another trend that I’ve noticed.  Buyers want much higher returns on investments than they did before the recession.  If cash is king, cash flow is princely.  If you’ve surveyed them like I have, they want returns ranging from at least 10 percent and more likely 15 percent plus.  A 7 percent unleveraged investment wouldn’t even take up ten minutes of their time.  There are just too many other “fish in the sea” to chase.  Besides, they need operating capital to survive this recession, so if the deal isn’t done to their liking, forget about it.

Of course, if you don’t calculate the unleveraged return on investment in the first place, you don’t have a yardstick to measure your BOA or ME on in the first place:(

John's Signature

Related Posts

Comments are closed.