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What is the right CAP rate for Minnesota resorts?

Before answer this question, it is important to understand that buyers and sellers can apply many different approaches for the valuation and appraisal of commercial real estate.  There is the GIM (Gross Income Multiplier) approach, the NIM (Net Income Multiplier) approach, the replacement cost approach, the EMV (estimated market value) approach and the comparable sales approach – just to name a few.  The use of these approaches varies depending on the property, the investor and the bank.

The most commonly used approach for Minnesota resorts is the Capitalization (or CAP) Rate.  Before we discuss why it is the most commonly used standard, it is necessary to understand what it is.
Simply stated, the Capitalization Rate = (Resort Sales Price)/(Net Operating Income)
Resort Sales Price = the asking price for the resort and
Net Operating Income = what it takes to run the resort

What is the Net Operating Income you ask?

Simply stated, the Net Operating Income = Gross Operating Income – Total Expenses + Seller Discretionary Expenses (SDE)
Gross Income = the total Income taken in by the resort that appear on the tax returns
Total Expenses = all resort expenses that appear on the tax returns
Seller Discretionary Expenses (SDE): this requires a little more explanation

When looking a resort’s profit and loss (P & L) for the year, some expenses are not directly related to what it takes to run a resort and are largely determined by the current owner. These are legitimate business expenses, but are variable due to an owner’s personal needs and preferences. A common example of this is depreciation. Other expenses that may or may not show up on the P & L statement are owner health insurance expenses, vehicle expenses, rent payments to another entity controlled by the owner, owner salaries, and owner payroll expenses. This is not a complete list and buyers should know what a seller considers Seller Discretionary Expenses (SDE). Every resort owner and resort is different.

Why is CAP Rate the most common standard?

First, this is a standard that is used and understood by investors throughout the United States and applied to lots of different properties.  Whether it is an apartment in Austin, Texas, a commercial high rise in Chicago, Illinois or a Starbucks store in Los Angeles, California, it is calculated the same way.  You can Google commercial properties for sale and see CAP rates for various properties.  In general, the “safest” properties (those that are easiest to operate and with the most reliable occupancy or lease) have the lowest CAP rates and therefore command the highest relative sales prices.  The more “complicated” properties (those that are more difficult to operate or those with  variable income) have higher CAP rates and therefore the lower the relative price.  As your evaluate your resort every year, you should consider if you are making your resort a “safe” or a “complicated” resort.  This shouldn’t deter you from making your resort more “complicated”-  you will undoubtedly enjoy the extra cash flow from these efforts!  You should however look at the long term impact these decisions have on your total “after tax” cash flow when exit your resort. This includes your yearly cash flow plus your resort’s sale price.

For example, renting your cabins seasonally versus weekly will undoubtedly make your resort “safe” and justify a lower CAP Rate, but your Gross Income will suffer so much over the years and at the time of sale – this is not a wise decision.  Conversely, if you decide to add an extra amenity that makes your resort “complicated”, be sure you will be able to offer this amenity for enough years to enjoy the extra cash flow to recoup the extra expense when you sell – otherwise this would not be a wise decision.

Secondly, as mentioned before, all resorts are different and SDE is different.  Some investors may consider the SDE part of what they will need to run the business because they are not interested in operating it themselves.  For buyers who are also operators, they realize the benefits of housing that is included along with the investment.  They also realize they can streamline the operation and the SDE (and other expenses) of a seller.  The calculation of Cash On Cash (COC) return is ultimately what everyone is interested in and everyone has different short and long term goals.  COC is different than CAP rate and I will cover that in another article.

Thirdly, and probably most important, banks use this as a convenient gauge to make sure any loans they make will get repaid.  The bank will require a complete appraisal for a resort loan and a complete appraisal will look at Comparables, Replacement Value, and Estimated Market Value, but ultimately the thing they care most about is will they get their loan paid back.  For this, they will lean most heavily on the CAP Rate analysis of the resort – this flows into their calculations for Loan to Value (LTV) and the Debt Service Coverage Ratio (DSCR).  The LTV and DSCR is what bank underwriters look at when looking at all the bank’s assets and the bank’s overall viability.  Yes, you can overcome bank objections but this requires a high net worth individual either willing to pledge other assets or make a larger down payment.  High net worth individuals didn’t become high net worth individuals by making poor investments, so you can see why overcoming this objection is tough for sellers.

So, what is the right CAP Rate for Minnesota resorts?

In general, the industry standard CAP rate for owner operated Minnesota resorts is in the 8 (a “safe” property) to 15% (a “complicated” property) range.  We understand that is quite a range, but we also understand there is quite a variable in the type of Minnesota resorts.  Some have multiple employees, restaurants, spas, property management, gas sales, cabins, houseboats, RV camping and are open all year round.  Some are owner operated, open one season a year and the cabins are all in tip top condition.  Those variables all drive the CAP rate that is appropriate to your resort’s sale price.  There are other variables too, but this is the starting point for most buyers.

If you are thinking about buying a resort, let Lake Country Resort Sales help you find the right resort for you based upon your needs.  If you are thinking about selling, let us help you determine a reasonable selling price for your resort.  Maybe you are not ready to sell right now, but you need some Exit Planning to help maximize your return.  We are here to help.  It is never too early to start planning.

-David Moe, Broker/Owner

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