Q: What is a good methodology for determining what an appropriate cap rate is?
A: As a general observation, I think it's safe to say that identifying an appropriate cap rate for a specific income producing property is usually more art than science. But we can offer some thoughts and guidelines.
A first step in establishing a cap rate for an income producing property in a given market is to check with appraisers and real estate brokers who work in that market. In addition, many local colleges collect and provide cap rate information. The key, of course, is to identify a cap rate for a recent transaction in which the income producing property closely resembles the income producing property in question. The more recent the transaction, the more useful the cap rate for this recent transaction. And the more similar the property, the more useful the cap rate for this transaction.
In the absence of recent sales and comparable properties, you might use the existing Baa bond rate as a reference point. The cap rate for an income producing property, in theory, should be greater than the Baa bond rate, since it likely is a riskier investment with a less predictable income stream. If prevailing cap rates in the market are, in general, lower than the Baa bond rate, it implies that investors are betting on price appreciation for income producing properties to provide the additional return on investment to meet investors' target rate of return. In effect, the Baa bond rate is a simple starting point or reference rate in attempting to identify an appropriate cap rate for the income-producing property in question.
Perhaps a more practical approach to identifying a cap rate is to back into it. To do so, use your very best efforts and resources to identify the current or most likely NOI of the property. That requires access to recent operating statements for the property along with rent rolls for the past couple of years. But once you feel comfortable with a most likely NOI, then determine how much debt the NOI could support given proposed financing terms and conditions, e.g., 6.00 interest with a 25-year amortization period and monthly payments. The debt constant for these financial terms is 0.077316. Therefore, if the property's most likely NOI were $100,000, it could support (($100,000) / (0.077316)) = $1,293,393 of term debt. Suppose the maximum LTV were 80%. If so, the implicit market value for this income producing property would be (($1,293,393) / 0.80)) = $1,616,741. If the proposed sales price were $2,000,000, the cap rate would be (($100,000) / ($2,000,000)) = 0.05 or 5%. If the proposed sales price were $1,500,000, the implicit cap rate would be (($100,000) / ($1,500,000)) = $6.67%.
More importantly, a sales price of $2,000,000 translates to an LTV of 64.67%, which is well within the LTV maximum of 80%. However, a sales price of $1,500,000 translates to an LTV of 86.23%, which would then require a reduction in the term loan to conform with the LTV maximum.
Keep in mind that the first way out is property cash flow, which requires that we assess and determine likely property cash flow as best we possibly can. Collateral is the last way out and is highly unpredictable, since the lender has no real idea when a bankruptcy might occur or what the property's liquidation value would be at that point.
Course overview: The Appraisal Report and Approaches to Market Value