As broker’s we get posed this question often. The
biggest driver of a community’s value is its current net operating income and
Cap Rates. Communities are typically valued be dividing its current
net operating income (NOI) by the current cap rate. A cap rate is
similar to an interest rate and measures investor’s perception of risk in a
given asset. A high cap rate indicates greater risk, and thus a
lower value.
When a property is not operating at its potential, net
operating income is lower than it could be and the value is thus lower.
Many owners think it might make sense to try to improve their community’s NOI
and then try to sell in the future. There are two main things an owner
needs to consider when thinking about this strategy. First, is it realistic
that their community’s net operating income will increase in the near future
without significant changes – capital expenditures/remodeling, a new management
company, new staff, etc. Does the owner have the ability and resources to
execute this changes? The community will not simply do better on its own
because it may have had success at some point in the past. The
industry is constantly changing and improving, and owners need to also continue
to change and improve to keep up. It is not simply good enough to keep
doing what you have done in the past and hoping things will improve on their
own. This strategy doesn’t work in any industry.
The second item to consider is; where will cap rates be in
the future? Cap rates are greatly influenced by interest
rates. As interest rates rise, so do cap rates, and thus property
values decrease. Although there is not a 100% correlation between cap
rates and interest rates, there is a very strong correlation between the
two. Since interest rates are at an all-time low right now, there is a
good chance that they will raise in the future, and cap rates will along with
them.
For example, a community is currently producing
$600,000/year in NOI and the current cap rate for that type of community is an
8%. To determine the value, $600,000 would be divided by .08 to
come up with a value of $7,500,000. However, the owner is not happy with
the value and decides to spend $300,000 on remodeling, hire a new marketing
director, and spend more of their own time at the community to help control
expenses. Over the course of two years, the owner increases NOI to
$800,000/year. However, during that time, interest rates increased
and now the cap rate for this type of community has increased to a
10%. The new value would be determined by dividing the current NOI
of $800,000 by .10, equaling $8,000,000. Thus, after spending $300,000 in
remodeling, the owner has only increased the value by $200,000 after working
hard for over two years. It is also possible, that NOI doesn’t increase
at all with a remodel and new marketing director because a competitor builds a
new facility close by and saturates the market, or the new marketing director
turns out to be worse than the original director, or the Executive Director
quits and the owner can’t find a good new one, or one of the many other
challenges that owner’s face every day occurs.
The biggest risk facing owners today who are considering
selling in the next several years are rising interest rates. If a
community is not preforming at its optimum, an owner has to realistically assess
if they have the ability, time and resources to make the changes needed to
truly increase the NOI, understanding there are many outside factors that could
inhibit their ability to execute the plan. The old saying, “A bird in the
hand is better than two in the bush” is often true today.
For a complete analysis of what your community is worth,
contact Jason Punzel –
punzel@slibinc.com or 630/858-2501
