Solving the “What’s the Cap Rate” Dilemma – Part 1 of 3

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Many deals for marina acquisition just don’t happen.  I’m not just referring to deals in the current recession… I’m addressing all market cycles.  “Meetings of the mind” don’t happen as much with marinas as they do with other common property types because there are greater perceptions of value differences between sellers and buyers.

DataI briefly commented on why there are so few marina sales years ago in an article by the same name.  Rather than try to explain the nearly infinite nuances of marina deals, let’s bring it down to simple math via everyone’s favorite financial unit of measure – the cap rate.

When a buyer and a seller have a meeting of the minds and agree on the sale price, both of them have arrived at the same cap rate or if their net income projections differ, a generally narrow range.  But when they don’t have that mind meeting, there’s a spread between the asking and buying cap rates that parallels the price perceptions of the two parties.  Let’s start to explain that.

What’s the Minimum Asking Cap Rate?

There’s a cap rate technique that you seldom see that helps us determine if there is any chance that the two parties can come to terms.  It establishes the minimum asking cap rate that a seller will require, so if the buyer is unwilling to lower his/her cap rate expectation to at least this level, they shouldn’t invest one second more on the deal.  It’s called the Equity Residual Technique.

The Equity Residual Technique to the Rescue!

The Equity Residual Technique (henceforth ERT) starts with the net operating income.  Let’s say the NOI is $200,000.  We subtract the annual mortgage payment to arrive at the before tax cash flow (BTCF).  So if the mortgage payment were, say, $150,000, we would have a BTCF of $50,000.  This cash flow reflects a return on investment to the buyer, so there’s a minimum return they need to get.  Let’s say it’s 8 percent.  If we divided the BTCF by 8 percent (0.08), that’s an equity value of $625,000.  We’re halfway home.

To this equity value, we simply add the mortgage balance.  Let’s say that it’s $1,500,000.  The result is $625,000 plus $1,500,000 or a property value of $2,125,000 via the ERT.

OK, so we can see that there’s an assumption that the mortgage is at market or assumable by the buyer.  Still, can you see the beauty in this type of analysis?  Allow me to illustrate in Part 2.

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