Lets Cap It Part 1

I recently played host to some Austrian consultants that
were interested in finding out what the hotel market in Abuja was like. After
talking for a while one of the consultants asked me the question that every western
consultant/developer/investor/money man  looking to invest in real estate asks; How do
you determine cap rates? I looked at him and smiled.

Before I continue I should probably rewind to explain what a
Cap rate is. Don’t feel bad if you don’t know what it is, I didn’t learn about
it until 2 years ago.  A cap rate short
for capitalization rate is basically what percentage return an investor is
looking for in an investment. You often hear people saying things like  ‘we bought it at a 15 Cap’. In a very
rudimentary way all that means is that investor bought an asset with the
assumption that he will be getting 15% on his investment.

A lot of things go into cap rate determination, and it can
get complicated so I won’t get too much into that. If you want to learn more
about it I would suggest going to www.getrefm.com/blog.

So back to cap rate selection. All it is, is a valuation
metric that people use to determine the worth/suitability of an investment. It
is particularly valuable in more organized societies where the following are
available:

The problem is if you are in economy like, ours in, Nigeria
cap rates essentially get tossed out the window, at least I do whenever analyzing
potential deals. There are a multitude of reasons why. The short answer is
basically because the 3 things listed above are non-existent. 

So you may be asking why would I toss out a valuation metric that people far more intelligent than me live by. See answer after the jump.

I toss it out because the cost of money is so high and the data is unreliable. Think about this for a minute. If you are borrowing in
Nigeria the lowest interest rate you can get borrowing domestically is 20%.
This means will be paying an extra 20% on whatever you borrow. Now assume a
ration 40% equity and 60% debt. If I had a N100,000 project this means that
annually I would be paying  N12,000 on
interest alone. So if I were to select cap rate for this project I would have
to select something higher than my cost of money which in this instance would
be cap rate that would give me returns higher than the N12,000 in interest
payments. 

At this juncture you are probably asking yourself why the
consultant was asking the cap rate question. The simple answer is when they prepare
the financial proformas/spreadsheets they need to model an exit. The exit is
simply a simulated sale at a pre-determined price to show what the investment
would look like after a certain number of years.  In order to determine the sale price they need
to multiply the net operating income (NOI) by the cap rate. In short the
consultants were picking my brain to try to get a better idea of what number
they should use to aid in the determination of the future sale price. 

So the million dollar question is what do you use instead of
a cap rate? Simply look at yield and decide of the yield the project is putting
out is worth it to you.