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Praveen Chawla
Praveen Chawla
Articles (46) 

Thoughts on the Cap Rate Metric and Simon Property Group

The cap rate is discussed in the context of the Covid-19 crisis

July 08, 2020 | About:

Cap rate is a financial metric used by real estate investors to analyze real estate investments to determine their potential rate of return. It is calculated based on the net income from operations that a real estate investment is expected to generate over the course of one year, which can help an investor make a decision on whether to buy, sell or hold and compare it with other similar investments.

When calculating the cap rate, we take the ratio of the net operating income to the asset value of the property. The property asset value, in this case, is the purchase price that an investor is willing to pay for the property or the asking sales price for the property.

The formula for calculating the cap rate is: Cap rate = Net operating income / Market value.

Let us look at the two components of the cap rate in greater detail.

Net operating income

Net operating income is the annual income expected to be generated by the property. It is obtained by taking the expenses incurred in the regular upkeep of the property and deducting it from the annual expected income. The expenses would include items such as property taxes, utility expense, insurance costs, maintenance fees, etc. The value should exclude the mortgage principal and interest payments as well as amortization and depreciation.

The GuruFocus database defines operating income as "sometimes also called Earnings Before Interest and Taxes (EBIT) , is a measure of a firm's profit that includes all expenses except interest and income tax expenses. It is the difference between operating revenues and operating expenses."

However, the GuruFocus database also subtracts depreciation expenses in its calculation for operating income (Ebit). We don't want that, but it can easily be fixed. So we need to add back depreciation, depletion and amortization expense to get at the net operating income.

Market value

Current market value represents the amount that a property can be sold or bought in the current marketplace. In the GuruFocus database, this is best represented by the enterprise value, which it defines as:

 "Think of Enterprise Value as the theoretical takeover price. It is more comprehensive than market capitalization (Market Cap), which only includes common equity. Enterprise Value is calculated as the market cap plus debt and minority interest and preferred shares, minus total cash, cash equivalents, and marketable securities."

Its basically the minimum price an owner (seller) will be willing to sell the entire enterprise to a buyer while paying off all creditors.

Now let us look at a practical example taken from the GuruFocus database: Simon Property Group Inc. (NYSE:SPG), a leading shopping mall operator.

1) EBIT for the trailing 12 months ended in March 2020 was 777.537 (Jun. 2019 ) + 837.303 (Sep. 2019 ) + 786.973 (Dec. 2019 ) + 687.248 (Mar. 2020 ) = $3,089 million

2) Depreciation, Depletion and Amortization for the trailing 12 months ended in March 2020 was 371.83 (Jun. 2019 ) + 343.359 (Sep. 2019 ) + 339.065 (Dec. 2019 ) + 340.265 (Mar. 2020 ) = $1,395 million

So net operating income is $3,089 million - $1,395 million = $4,484 million

3) Simon Property Group's Enterprise Value for the quarter that ended in March 2020 is calculated as:

  Enterprise Value (March 2020)
= Market Cap + Preferred Stock + Long-Term Debt & Capital Lease Obligation
= 16773.7193 + 42.338 + 28074.791
+ Short-Term Debt & Capital Lease Obligation + Minority Interest - Cash, Cash Equivalents, Marketable Securities
+ 0 + 329.354 - 3724.853
= 41,495

So the cap rate is: 4,484 / 41,495 = 0.10806 or around 10.80%.

Note that the numerator of the equation is operating earnings over the trailing 12 months. However, we know that Simon Property's operating earnings are being deeply affected by the Covid-19 crisis. So if we take the March 2020 quarterly number and annualize it, we get the current annualized net operating income: 687.248 + 340.265 = 987.513.

Multiplying this by four, annualizing the quarterly figures, gives us 3,960.05. This is our current annualized net operating income. If we use this number in the above calculations, we get 0.095, or about 9.5% cap rate.

Generally, the higher the cap rate, the more attractive the investment is to the buyer (the opposite is true for the seller).

Simon Property's cap rate can be plotted over time and I have done so below (I used the customized series function to construct the series). Since cap rates for REITs are heavily affected by interest rates (real estate is built with borrowed money), I have also plotted the 10-year Treasury yield. Currently, Simon Property's cap rate is about 10%, which is twice that of a few months ago (it was around 6% then). This is mainly because the company's share price has imploded as many of its shopping centers were closed due to Covid-19 pandemic. The malls and shopping centers are slowly reopening, but we are not sure how many of the retailers can survive and pay rent. Expect a lot of volatility as cap rates for Simon Property settle to equilibrium as we navigate this recession.

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Disclosure: The author owns Simon Property Group stock. 

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Rating: 4.0/5 (1 vote)

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Comments

megabaloneysandwitch
Megabaloneysandwitch - 2 months ago    Report SPAM

Many mall tenants like GAP are playing hardball with landlords like Simon arguing for rent reductions in light of the abrupt drop in mall traffic. Others simply failed to pay their rent in April and May. Some will go bankrupt due to the impact of the pandemic. The likely result is falling occupancy and a decline in average rents: even for high-quality malls.

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