Seller/Buyer disconnect in NNN Underwriting? Specifically TI/Commissions impact on cap rate math and value comparison?
We've bought several multi-tenant NNN buildings recently and are very happy with the performance.  We're continuing to look at and underwrite more.  We have a fundamental question that I was hoping the sub can provide some input on. 

Obviously cap rate is a function of NOI/price.  When looking at a project OMs/Sellers take the true operating line divide by price and that's CAP.  So, say $100K of NOI/$2M sale price = 5 cap.  

My issue/question is what about reserves/TI/commissions/etc.?  I get CAPEX is below the line.  Should not at least TI/commissions be in the operating line for purposes of cap rate calculation?  If one doesn't blend that anticipated expense into the cap calculation then wouldn't there be a pretty significant difference in expected return between deals with say a 2 vs 10 year WALT at the same cap rate?

Really interested in input from the various viewpoints - buyer, seller, lender, etc.
[{"id": "goncjye", "text": "You include TI/LC\u2019s in your returns, but never in cap rate. It\u2019s not an operating expense.", "replies": [], "depth": 1}, {"id": "gondarz", "text": "This is a common issue in office too. Cap rate is only guidance. A brokers or sellers cap rate it usually thinned out of many relevant expenses and as such will definitely not equal a buyers long term distributable income. \n\nPerspective: Real estate private equity investor", "replies": [], "depth": 1}, {"id": "gone6g1", "text": "Cap rate is just a metric that brokers use )and it factors in TI/LC / growth rates) but it\u2019s largely meaningless. The important thing is what\u2019s your strategy - are you looking for CoC returns? LIRR? UIRR? You\u2019re ultimately DCFing all cash flows to get to your value so back to point 1 cap rate factors this in but it\u2019s kind of meaningless in a vacuum. I\u2019ve bought a ton of 0 cap rate deals and a ton of 50 cap rate deals, they story is in what you\u2019re buying / what the business plan is. I guess if you want to go on cap rate the more relevant metric for you is what\u2019s stabilized yield which is your rolled over rents / current basis + TI/LC/capex.\n\nAlso in NNN buying deals with like 2 years left of WALT is bad unless you\u2019re buying like your 30th CVS", "replies": [{"id": "goo0s3p", "text": "I agree for sure on the 0 cap rate. Bought a bunch of vacant multifamily in the last downturn, for example.\n\nOn the 2 year WALT point.  Isn't that effectively your point here:\n\n\\&gt;   I guess if you want to go on cap rate the more relevant metric for you  is what\u2019s stabilized yield which is your rolled over rents / current  basis + TI/LC/capex. \n\nThat is,assuming I'm confident in releasing then if I discount for anticipated lease roll (vacancy, lease up, TI, etc.) that's just somewhat equivalent to a value-add strategy, no?", "replies": [{"id": "govmcee", "text": "Would you please show the calculation of a 0 cap rate?", "replies": [{"id": "govtmiv", "text": "Bob, you're back!  OK, you want u/stoweker and me to say we bought at negative caps because there's always property tax, for example?  Fine, you win this one.", "replies": [{"id": "gow0scx", "text": "Not at all.  I asked you to show the math for a negative or ZERO cap rate.  You both seem stymied when asked to factually state your case.  I mean I'm not gonna call BS but if it looks and smells............well.  You either can or cannot show the mathematical progress to your determination.", "replies": [{"id": "gowona0", "text": "My man...take the win.  You're like a moth to light on cap rate conversations.  You have a bot that searches for posts with cap rate in them?\n\nThat said, and admittedly I'm a simple man who I guess intuition has led to doing ok with this real estate thing (in the situation I referenced it was a vacant 150u+ building) here's some math.\n\nI pay $1M.  My only expense is $100K of property taxes.  CR = NOI/Price.  So:\n\n-100K / $1M = -10% according to my rudimentary calculator.\n\nBut, again, I'm with u/stoweker that everybody I've talked to just calls that 0.\n\nIn that scenario, what would you say cap rate is?", "replies": [{"id": "gozd9g9", "text": "Um, where's the NOI   ?????   Your calculation is Property tax/some made up purchase price = a number that you are incorrectly calling a cap rate.  That is a CRAP rare at best.  You have to do better than just making up stuff.   Can you?", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "gouaxa9", "text": "What would the math look like on a 0% cap rate?", "replies": [], "depth": 2}, {"id": "gp1t6gw", "text": "Hey u/stoweker why did you delete all your incorrect posts?", "replies": [], "depth": 2}], "depth": 1}, {"id": "gonigjs", "text": "Brokers never include an expense they don\u2019t have to. 98% of NNN lease listings don\u2019t include anything for expenses.", "replies": [], "depth": 1}, {"id": "gonjabw", "text": "Yea agree with Harry. We typically look at the stabilized yield on cost to get comfortable with the price. So stabilized NOI/value plus all costs to get you stabilized. I work for an institution though. Not sure if that\u2019s how small private buyers would look at a deal.", "replies": [{"id": "goo0dpk", "text": "I think this is close to what I was thinking.  That is, I guess \"broker\" cap rate is maybe a interesting first filter but ultimately, even when cap rates are the same and all expenses are actually loaded the valuations to me are inherently different just based on lease roll for example.  Appreciate your (and others) responses.", "replies": [{"id": "gop0pny", "text": "Agreed. You have to factor in that lease roll risk to the price as you are taking on much more risk and will likely have much more costs to re lease the space. I would definitely fully vet the brokers numbers and rates and come up with your own. They work for the seller.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gonncth", "text": "Everyone uses the number that will result in the best outcome for their side and try to show the other side that their number is correct.", "replies": [], "depth": 1}, {"id": "gontj95", "text": "Below the line, similar to mortgage.", "replies": [], "depth": 1}, {"id": "goo2rrd", "text": "I usually see TI/LC in non-operating expense or Capex depending upon treatment but we are usually not working with GAAP/IFRS standards here so really just always know what each metric comprises of. Even when people quote cap rates (again no GAAP standardization) so it can be anything in the numerator and denominator... I try not to assume. \n\nAnd, of course, conduct your own underwriting and develop performance standards based on your deals and experience.  Different KPI\u2019s lend different insight into the risk/return of a particular deal. Use what works for your processes.  Historically, I\u2019ve focused on IRR, profit and multiple as the cursory three. But the devil is always in the assumptions and stress testing. My 2cents.", "replies": [{"id": "goo5sw4", "text": "Appreciate the comments (and other posters). That trifecta has been what I've been looking at but the disconnect on value on my underwriting has been making me feel a little crazy given that it's a relatively new asset class for us.", "replies": [{"id": "goo74rd", "text": "Totally understandable. Depending on the asset class you are used to, PERE may seem like the Wild West. Just a lot of cowboys spitting off cap rates and doing 50M deals. Ha!", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "goq4nw5", "text": "&gt;     Should not at least TI/commissions be in the operating line for purposes of cap rate calculation? If one doesn't blend that anticipated expense into the cap calculation then wouldn't there be a pretty significant difference in expected return between deals with say a 2 vs 10 year WALT at the same cap rate?\n\nThink of the cap as measuring the risk of an asset against other similar market properties.  This is very useful to arrive at a stable value, not so much for unstable for the reasons you noted, nor is it particularly great at projecting actual returns.  Including these non market cap/ti/com/etc expenses into the operating expenses would create two errors, one would be an assumption these expenses are regular and will repeat, and it would cause the cap rate to incorrectly assess the true risk level of the property which is important because you are presumably comping against other cap rates.\n\nYou don't just ignore that stuff, but typically you either discount it off the price you get from using the cap valuation.  At least that is the quick and dirty way for immediate non operating expenses (leasing,known repairs, etc).    For longer term stuff like WALT/poor condition but not requiring immediate expenditure/higher than avg reserves etc this is basically why IRR/DCF exists.\n\nAs a more simple way of looking at it consider a 100k NOI property with a 10cap that needs a 100k new roof.  It isn't worth 0 obviously, which is what would happen if you did it the way you were kinda inferring to.  It is worth 1 mil - 100k (roof price) - $x (whatever markup you use to figure out your entrepreneurial incentive).\n\nLikewise too if this property is say half vacant you need to be adding income that doesn't currently exist into the NOI to get to stable.  This is more rare but you occasionally go the other way too if you have over market leases.\n\nAlways value stable then adjust to current condition.", "replies": [{"id": "goqa305", "text": "&gt;Including these non market cap/ti/com/etc expenses into the operating expenses would create two errors, one would be an assumption these expenses are regular and will repeat\n\nI get it, but by definition TI at least and lease commission - assuming it's not \"free\" in house - are recurring.  We're not generally looking at a building on a 100 year lease to the US Treasury with no outs, right?  We're buying a set of leases that have inherent roll, they'll be replaced with other similar leases with inherent roll, and there will be costs associated with that roll.\n\nSo - and I know you know this - take multifamily which is much more my historical background.  If I look at a P&amp;L, leasing costs and make-readies will be above the line.  I'm with you on the roof and other CAPEX reserves being below the line and that being - as other posters have discussed - differentiating pure cap rate from your actual underwritten investment return.", "replies": [{"id": "gor7lg6", "text": "the difference is above the line should generally be market type expenses that occur annually and can be budgeted/forecasted as such.\n\nfor mf turns/leasing costs etc occur on basically a daily basis, one year shouldn't be much different than another on a stable property.  If it isn't stable, you are back to capping stable and working through a rehab/stabilization type analysis.  If you look at some small office monthly type rental properties you will see similar things.  \n\nIf all this was above the line basically we'd be comparing irr's not cap's by the time you worked it out in a sophisticated way, and that information just isn't available for most comps.  Caps are fast and easy so they are a good metric.  It doesn't mean additional analysis may not be needed.  So if you know the subject property has some weird shit going on with the leases or reletting a space will be particularly costly from a ti perspective, it makes more sense to adjust after the cap analysis since you are dealing with conditions on your subject not the market.  If your subject is average in most ways it doesn't mean it won't have any of the expenses we talked about, it just means as a comparative metric the cap rate already is adjusted for that since it comes from other market sale comparables which you expect to be similar.  \n\nWhen you pick your comps you should be taking this into account btw.  Like when you look at say a walgreens NNN the cap rate you use will be based on comps with the same lease term remaining typically.  \n\nYou are asking a cap rate analysis to do more than it is designed to do.  It works well in MF because most market properties have similar expense profiles (and when they don't you try not to comp off them, like you would expect a utils paid property to by higher cap than seperated).  \n\nRetail and office just have more ways to break a cap rate analysis which is why DCF is typically used on them.  That is ultimately the answer to your question I think.  \n\nCap rate analysis breaks in MF too btw, I'm sure you've experienced investors and folks who are so smart they only buy on actual caps or folks who only want 12+ caps or talk about a smoking deal they got a 15 cap!.  Meanwhile smarter investors are using stable proforma caps to value to market then adjusting, and they are way more likely to get good deal done or avoid bad deals than the guys buying on cap.  In a reverse of that you can fairly accurately price absolutely huge properties with almost no info than the NOI if they are already stable.\n\nIt is all just a matter of understanding what metrics you are using, why you are using them, and making the right adjustments as needed, like for leases coming due etc that your comps probably don't have.", "replies": [{"id": "gorzef0", "text": "&gt;When you pick your comps you should be taking this into account btw.  Like when you look at say a walgreens NNN the cap rate you use will be based on comps with the same lease term remaining typically.\n\nYeah, I'm seeing that it really is about comparing similar tenant/lease term and you are right about the I guess I'd call it discomfort relative to MF - and the idea that MF term and roll is basically the same once stabilized.  And if it's not it's essentially startup capital and either budgeted or discounted depending on your perspective.\n\nI had intuited this comparative lease term a couple days ago and that partially was my motivation for the post.  As I was talking to our Ops folks about this, a 5 year WALT doubles my out of pocket on TI/Commissions relative to a 10 year WALT.  I'm looking at a small thin deal now that that expense drops my IRR like 200 bps.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gpfp9u5", "text": "This is a joke for people to be posting on commercialrealestate when they have no clue what NOI or a cap rate is but attack those that are trying to educate them and delete their posts and downvote people that know what they are talking about.\n\nAnd for people to consider themselves knowledgeable and flout around their so called Wall Street jobs.  Great way to kill a subreddit.  Mahalo cowards.\n\n&amp;#x200B;\n\nWadda ya think u/joshualyman and u/stowerker  ?", "replies": [], "depth": 1}]