Pushing Dirt

Question - What is net operating income? Does it equal cash flow available for debt service?

Answer - The fact is that net operating income does NOT equal cash flow available for debt service.  Items like a capital reserve, major capital improvements, tenant improvement expenditures, and commission expenditures need to be subtracted from net operating income to get to that bottom line of “cash flow available for debt service.”

As such, a capitalization rate (net operating income divided by purchase price), while a good sort of yard stick or rule of thumb indicator, is not a necessarily a particularly good indicator of yield. Consider two different investments:

• Building A is a brand new 30′ clear warehouse leased to the US Government on a long term basis, and
• Building B is a 1980s office building with 20 tenants, local and regional credit, with gradual lease rollover.

Both trading at a purported “10% cap rate.”

Building B is going to require recurrent tenant improvement expenses and leasing commissions where Building A does not.

So why buy Building B?  Well, there are potentially lots of good reasons. Perhaps the rents in Building B are below market. There is arguably less risk in building B, because if a single tenant moves out, you’re left with an empty building. Perhaps building B is located in a better market with more dramatic rent growth. Perhaps the price per square foot of building B is well below replacement cost, and in the case of building A you’re paying more than it would cost to build the building.

So it just goes to show you that a cap rate should only begin your underwriting. You’ve got to take into account return of time (internal rate of return), the market, the building condition, and on and on.

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