(12-03-2015, 01:00 PM)johnnydash Wrote: [ -> ]In reply to Boon:
I have to disagree with you respectfully. NOI does not include maintenance capex, when used together with the cap rate.
NOI used in conjunction with cap rate is one way of checking for valuation of property, of course it is extremely useful for broad view, but more importantly, it allows for comparisons. So right now cap rates of hotel in singapore is about 5, and that cap rate came about because market participants use NOI that does not include maintenance capex. So if the norm was otherwise, then the cap rates will adjust downwards accordingly. Cap rates are not just used before transactions, but they are often(perhaps more often) used by analysts post transactions. It is a tool at the end of the day, and the context and how its used is important. As a very clear illustration of one way cap rate is used, you may refer to IPO of the hotel fund listing in recent years, the one that acquired a number of properties in Australia(the name has slipped my mind). Actually other such IPOs prospectus should be able to perform the same role.
You are right that some buyers will consider refurbishment required in the future, and you may think that going forward there will be significantly higher proportion of such buyers(i dont see any reason for this), but its wrong to calculate what the buyers will be willing to pay by simply using the method you have discussed, for the reasons mentioned above. Perhaps you can say that more buyers are demanding replacement value, and so valuation of hotels will drop. But analysts has and will still continue to use NOI and cap rates the way it has been used in the past. If you want to use NOI considering maintenance capex, then you have to account for the adjustment in the cap rate as well but im not sure how one can do that in way to reflect market conditions.
Hi johnnydash,
Please refer to the below article, parts of which are pasted below
Leasing Expenses: Above the Line or Below the Line Expenses and Does It Matter - Part 1
http://www.commercialappraiser.com/more/...er-part-1/
There is no universally accepted practice for the treatment of replacement reserves and leasing expenses (tenant improvements (TIs) and commissions) in the income statement developed by commercial property appraisers as a basis for estimating value using direct capitalization. While it is often the case that these are capital items, falling below the NOI (net operating income) line, which is capitalized into a value estimate, such costs may still have a sizeable effect on value and should not be ignored. Additionally, it is not always the case that these are capital expenses and so would be properly included as an operating expense in the commercial appraiser's reconstructed operating statement .
The Dictionary of Real Estate Appraisal defines net operating income (NOI) as the actual or anticipated net income that remains after all operating expenses are deducted from effective gross income but before mortgage debt service and book depreciation are deducted.[1] It equates to the definition to EBITDA (earnings before interest, taxes, depreciation, and amortization) used in corporate finance and business valuation. EBITDA does not include capital expenses, which are monies meant to acquire or improve an asset, e.g., land, buildings, building additions, site improvements, machinery, equipment;
as distinguished from cash outflows for expense items that are normally considered part of the current period's operations. Such costs depreciated over the asset's useful life.
Repairs, even significant ones, that do not extend the asset's life, however, are treated as routine operating expenses and so are reflected in NOI. This is where things begin to get fuzzy from an appraisal perspective. How are items such as reserves for replacement, tenant improvements and leasing commissions properly handled?
Do such expenditures extend the life of the asset making it a "below the line" capital expenditure or
do they merely return the asset back to its previous condition making it an "above the line" expense? Does it matter?.......................................
…………………………………………. Depending on which level of income is capitalized, this transaction produces at least three different capitalization rates.
There is a common misconception that each property or property type has a single unique cap rate, but this is incorrect. In fact any number of cap rates can be extracted from a single sale depending given the host variations possible for the computation of income: e.g. whether it is projected income or trailing income that is capitalized; whether or not the income is stabilized; whether it is contract rent or market rent that is capitalized; whether or not adjustments for vacancy and collection losses are considered; or what level of income is capitalized. Cap rates vary by geography, with property age, based on the strength of tenants, length and terms of leases, with market conditions and interest rates.
Applying a capitalization rate suitable to one method of computing income to the wrong income stream produces a spurious result. In the example above applying the cap rate extracted from the this sale using Method 3 (cash flow after reserves and leasing expenses) to a subject’s NOI before reserves and leasing expenses would result in an over valuation by more than 18%— $2,490,000 (roundly) vs. $2,100,000.
So which method is right? Since 80% of investors use Method 2, capitalizing NOI before reserves, TIs, and leasing commissions, shouldn’t that be the method commercial property appraisers use?
No, not necessarily. This isn’t the type of situation where “majority rules.” There are good reasons for applying any one of the three methods. For example, appraisers almost routinely consider replacement reserves in their reconstructed income statements, which equates to Method 1. This is because the direct capitalization method is premised on the assumption that the single year’s stabilized income reflects its potential earnings, now and in perpetuity. Therefore, an allowance for replacements is charged against NOI on the premise that periodic replacements have to be made of short-lived items such as water heaters, heating units, roofs, paving, parking lots, landscaping, exterior finishes, etc., to maintain the optimum rental status of the property and to reduce the escalation of maintenance and other operating expenses that may result from the deferral of necessary capital expenditures.
……………………………………………The author concludes, “Each of the methods for developing NOI can be the most appropriate, depending on the appraisal assignment.”[14]
So far we’ve pointed out that data from a single property transaction can produce multiple cap rates (i.e. that one size does not fit all) and secondly, that applying a cap rate derived form a comparable sale or survey using income calculated in one manner to the income for an appraisal subject that is calculated using another method produces erroneous results. A third item to note is that as one moves down the income ladder in the hypothetical example above, the capitalization rate gets smaller. Obviously, as more expenses are taken out, income declines and so does the cap rate. Also true, is that a cap rate is a measure of risk, or uncertainty. Assuming the accuracy of the data, as the specificity of the income model increases, uncertainty is diminished and the cap rate falls. So there may be a real advantage in explicitly considering the impact of such below the line expenses as leasing expenses. After all, the risk profile of property where half of the tenants have leases that expire within the next 12 months is much different than one having leases expiring two or three years out. Just because leasing expenses fall below the line from an accountancy perspective, these potential costs cannot be ignored in an appraisal. The buyer of such a property would certainly be well of aware of these forthcoming expenses in his purchasing decision and will plan accordingly.
The argument for commercial appraisers for capitalizing income before reserves generally follows from accounting definitions that these are capital costs and not operating expenses. In point of fact however, as Francis observes, the majority of investors amortize short-lived building components, including leasing expenses (TIs and leasing commissions) over the lives of the underlying leases and do not depreciate them over the life of the building. As much as anything else, the practice of capitalizing income before reserves is a marketing stratagem to make the property appear more attractive because both the NOI and cap rate are higher; nevertheless, as Francis also points out in his article, sophisticated investors are well aware of these costs.
Even in corporate finance and business valuation, practitioners warn against exclusive reliance on EDITDA as a performance measure and value indicator. Warren Buffet is famously reported to have asked, “Does management think the tooth fairy pays for capital expenditures?”
(not vested)