by Jack Corgel, Senior Advisor to PKF Hospitality Research and the Robert C. Baker Chair of Real Estate at the School of Hotel Administration at Cornell University
During periods of cyclical decline in hotel markets like the one now being experienced, the closely-followed hotel capitalization rate transforms from an easy-to-understand ratio into a complicated puzzle. The capitalization rate (R) defined as R = NOI/V where NOI is the net operating income of a property and V is the property value (also price depending on market conditions), serves two functions in investment and financial analysis. These are,
Capitalization rates indicate overall rates of return on investment without considering proceeds from the sale of the property in the future. Thus, the investment is V and the monetary return is the NOI. The NOI provides both the income needed to pay debt service and to reward the equity investor, hence the term ‘overall rate of return.’
Capitalization rates are used to estimate the value of property. Assume a hotel’s NOI is estimated to be $500,000, and using one of several methods available to appraisers, an estimate of the current capitalization is 10.2% then the estimated value becomes $500,000/.102 = $4,901,960.
Confusion arises, particularly during times like these, from the tendency to mix the two functions of capitalization rates when determining what goes into the numerator and denominator of valuation equations. If NOI is defined one way the capitalization rate aligns with the overall rate of return function, if defined another way the capitalization rate aligns with the valuation function. Three alternative NOI definitions commonly appear in practice. First, NOI is measured as the recorded income during the past year – trailing 12. Second, NOI is the expected income over the next year – forward 12.Third, NOI is the expected income when the property has a stabilized occupancy – stabilized NOI. During times when markets are not in transition, forward 12 and stabilized NOI will be very close to one another if not identical.
Each measure leads to a period-specific overall rate of return interpretation of the capitalization rate. The trailing 12 NOI is the overall rate of return for the past year, forward 12 is the expected return for the next year, and stabilized NOI is the long-run expected return. Only one measure – the stabilized NOI – aligns with present value theory which says that value derives from the stream of future income.
To illustrate, consider the following example:
Assume three comparable hotel transactions occurred during early 2009 at $1M, $2 M, and $3 M, respectively. Exhibit 1 presents the trailing 12, estimated forward 12, and estimated stabilized NOIs for the three properties. These NOIs differ because the market has been in transition from a cyclical peak toward a trough. The average of the capitalization rates equals 9%, 10%, and 10.7% depending on the NOI assumption selected. The sellers of these properties earned a 10.7% overall return in 2008 while the buyers will earn a 9% overall return during the next 12 months due to the decline in NOI. The long-run expected overall rate of return is 10%. Potential buyers in the market today armed with this information about the comparables will argue that the transactions resulted from pricing based on trailing 12 NOI, while sellers will argue forward 12 NOI.
The central question then becomes – which is the theoretically correct capitalization rate to use on a subject property with a trailing 12 NOI of $300,000, an estimated forward 12 NOI of $250,000, and stabilized NOI of $325,000? The correct answer is to capitalize the stabilized NOI of $325,000 by the stabilized capitalization rate of 10% obtaining an estimate of market value equal to $3,250,000. Any other combination of NOI in the numerator and capitalization rate in the denominator is inconsistent with present value theory and therefore results in estimates of value that are not market value estimates.
