Understanding Capitalization Rates

Video Transcript

Robert: My name is Robert Bonavito, New Jersey Forensic Accounting. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only. If this was a litigated matter, I would take a different approach, have different conclusions based on different facts and circumstances.

Today's discussion is gonna be understanding capitalization rates, and I could spend months if not years discussing this topic because it's so interesting. And the whole financial market is kind of based on these cap rates. We could figure out values and discounts and stuff like that and how much you're going to make or lose.

So, I want to talk a little bit about again, a basic overview of capitalization rates. I'm going attempt to answer a complicated question with simplified solutions. And the question again is, what is a cap rate? In a nutshell cap rate is a return that investors will expect on an investment in your company.

And when someone invests in a company, hopefully, they're thinking of what kind of rate of return they're going to get on their investment. Because they could have done other things with their money, right? They could have bought a car. They could've went to Italy, whatever. They could do a lot of things with the money, and they put it in your company, and they want a return.

Once you have this, what's called capitalization rate, you can value a company. It's as simple as taking the cash flow, I have some other videos where I go into more detail. But you can value any company if you get the cash flow and you get the capitalization rate.

And one thing... you know, people talk about capitalization rates and discount rates. Whenever I'm in a seminar or giving a seminar, people will say, "what is a cap rate?" Or "what is the discount rate?"And let me just tell you how to get from a capitalization rate to a discount rate.

If you simply add the growth that you expect, let's say you have a capitalization rate of 15% and you expect 3% growth into the future, you simply add that to it and that will give you a discount rate.

So, if you have a discount rate, you can just simply subtract the growth and again, this is the growth in the investment. If you're expecting a company to grow at 10% or let's say at 2%. So, you have a capitalization rate of 15, means you have a discount rate of 17. And once you have those rates you can do all kinds of stuff. Discounted cash flows, capitalization rates and every day we use that stuff, it's important to kind of understand how we get that.

Let me just give you a simple example again. This is a cash flow, let's say it's 40 million dollars, and I have a cap rate of 11%. How would you get a discount rate? You just increased the growth, whatever. Like if I'm saying that the cash flow is going to grow by 2% a year, I can say 11 plus 2 is 13, that will give me the discount rate. And if I have these two numbers I can then say this company is worth 363 million dollars.

Sometimes a cap rate is referred to as a hurdle rate, and this means that the minimum rate a company needs to earn on its projects. And if you ask anybody, any chief financial officer, "Hey what is your discount rate?" They probably won't tell you, it's a secret, but they know it and maybe they'll give you a range because no one really wants anybody to know what their cap rate is because then they'll know what kind of investments they will take, because everything to dealing with financing these companies, especially the larger companies, they spend lots of time figuring out what their capitalization rate is. So, when they have a project, they can calculate whether they should do it or not.

Because sometimes you'll see companies will sell or close plants and you're scratching your head because you're like, "Hey this plant was making a lot of money, and it was paying jobs and everything." The reason they closed that plant is because someone did an analysis and said our cap rate 15% and we're only earning 11%, and so we're actually losing money on that. But from an outside investment, you say, "Well, you're making 11%, 11% is 11%.

Well, let me give you an example, let's say I offered you a job making \$20 an hour, but it cost you \$22 an hour to get there, would you do that? Would you take that job? The reason you wouldn't because every hour you work you'll be losing \$2, but you're making \$20.

This is the same thing with a cap rate. And, you know, when I go into companies I figure out what their cap rates all the time because I don't want them losing money even though you're making money. It sounds kind of crazy but unfortunately when those companies closed down, those plants in the Midwest in the 80s and 90s, the reason they did is not because they weren't making money, but because they were making money, they just weren't hitting the hurdle rate. And so the company ended up losing money and what happened was somebody else came and bought that company who had a lower capitalization rate.

Unfortunately, a lot of the jobs went overseas, but they're coming back now, okay? Because their cap rate's coming back, and through technology and stuff like that, we can be more efficient, we can make more money. And so if you have a cap rate of 15% and you're making 10%, they're going to close that factory because they're losing 5%, just like you're losing \$2.

But let's say through technology or some other means, they're able to increase the profits up to 17%. They improve the products. They make money from their shareholders. They employ people. They will invest in that plant.

So, that's why it's so important to have a good understanding of your cap rate? Because it really comes down to, are you creating value or destroying value? And I go into these companies a lot of times, and I'm looking at these business managers and saying, "You guys are destroying value." And they're looking at their numbers, "Hey we made 10%, we made 8%," and I'll say, "Yeah your capitalization rate is 22%, you're not making money. You're borrowing from the banks. You're borrowing from shareholders, you're not meeting the cap rate."

And so you should put this thinking into your... you got to think like this too because even in your personal life if you're taking a job where you're losing money, you may not want to do it unless down the road things are going to change. Because like I said if I offer you a job for \$20 but you need to make \$22, or it will cost you \$22, like if you have education and stuff that you have to...you know, lot's of loans and things you have to pay. Well, you've got to find a job making \$22 an hour to break even.

And you know unfortunately it's not that simple in real life, but that's how the bigger companies do it. And that's why you have companies like GE and Ford and all these other companies that have been around for hundreds and hundreds of years. Because they know their cap rate, they know when they can do a project and when they can't do a project. And that's why they're going to be around in another hundred years.

My name is Robert A. Bonavito, CPA, if you have any questions feel free to call me or e-mail me. Thank you.