I further pointed out that since the NOI is the result of subtracting expenses from income, it is imperative to qualify those two numbers. The objective is to verify that you are using numbers that accurately represent the operation of your real estate. The income side of the profit-and-loss statement could cause that income to be artificially more than a representative number. That is why extensive, knowledgeable due diligence is a required prerequisite to all real estate purchases. The following are some examples that illustrate this point, and would immediately change the capitalization rate.

• The total income for that time frame may include non-recurring income.
• The time frame being applied might exclude rebates and/or discounts that the lessee is contractually entitled to.
• Do the current leases have annual rate increases that are consistent with future expense projections?
• The time frame being used might not show a large number of leases that are expiring at the same time.
• How do the rental rates of expiring leases compare to the current market?
• How long are delinquent accounts receivables being carried? It might be time for a writedown or write-off.

The expense side of the profit-and-loss statement could appear artificially lean through accounting methods, time frames, and management philosophies. Some of those methods are illustrated in the following progressive sequence: One of the first qualifications that has to be determined is the accounting method for expenses. Are expenses being shown on a cash basis, accrual basis, or some combination of both? Once the accounting method is determined, then the next series of questions becomes determined. If there are certain expenses that are being carried on a cash basis, then you would be looking for those changes that are not within your time frame. There may be cash outlays that are gray as far as being expensed or capitalized. Preventive maintenance programs should be examined for slowdowns or stoppage. Sometimes cash flow is just deferred maintenance.

About this time I pointed out to the pension fund manager that this is only a brief summary of the due diligence that is necessary to evaluate and conclude an accurate capitalization rate. Since it was confession time, I prompted the portfolio manager to fill in some more of the details from his transaction.

The fund bought a relatively new 110,000 square foot office building. The cap rate was 6.15 percent. The income and expense assumptions behind the NOI were based on a 12-month forward pro-forma. No adjustment was given for a significant lease expiring eight months into the holding period. The building was 88 percent occupied, with a financial guarantee creating NOI equal to 95 percent occupancy. The additional NOI being created by the financial guarantee carried no adjustment of the price. There was no adjustment for future leasing commission expense for the vacant space. There was no clear cut explanation covering the cost of tenant improvements for unleased space. Some of the leases were given early concessions, which when amortized over the term of the lease reflect a lower general rent. This lower amortized rent could be more reflective of the current market.

The unfortunate result of the purchase described above is that most often stated quote: “The first year cash flow didn’t meet our expectations,” followed by, “maybe we paid too much.”

I don’t know if he was the exception or the rule, but I do know one pension fund manager who will never again accept a capitalization rate at face value.

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