Understanding Cap Rates and Using Them in Investment Decisions
What Is the Capitalization Rate?
It’s a metric you come across frequently if you read about commercial real estate transactions: “Property X traded for $Y at a cap rate of Z%.” What exactly is a cap rate, anyway?
A cap rate (short for capitalization rate) is nothing more and nothing less than the expected rate of return on a commercial property investment. Another way of looking at it is to describe the cap rate as a measure of the profitability and return potential of the investment, based on asset value.
It’s important to note that, for purposes of determining the cap rate, “asset value” does not equal purchase price. That is because a cap rate assumes that a property was purchased all-cash, with no mortgage factored in.
Also, a cap rate should not be used as the sole factor in determining whether to make a purchase. And while Realty Mogul describes the cap rate as “a quick and easy way to calculate value,” the firm also notes that there are limitations in this measure, which will be discussed later in this article.
Cap Rate Formula
A cap rate is most commonly calculated by dividing a property’s net operating income (NOI) by the current market value, according to prevailing market rates. NOI is the expected annual income generated by the property (based on rental or lease income, for example) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include regular upkeep of the facility and property taxes.
Property Metrics provides the following example of a cap rate calculation based on this formula: “Suppose we are researching the recent sale of a Class A office building with a stabilized NOI of $1,000,000, and a sale price of $17,000,000. In the commercial real estate industry, it is common to say that this property sold at a 5.8% cap rate.
“To estimate the market value for a property, an appraiser might use several recent sales like this to derive a market-based cap rate for Class A office buildings. Suppose our Class A office building generates a stabilized NOI of $900,000, and we want to know what the building is worth. If an appraiser derives a market-based cap rate of 6% for our market, then we can divide our $900,000 NOI by 6% to estimate a market value of $15,000,000.”
Another formula for determining the cap rate based on the original capital cost or the acquisition cost of a property. However, according to Investopedia, this formula is not very popular for two reasons: it gives unrealistic results for old properties that were purchased several years/decades ago at low prices, and second, it cannot be applied to inherited properties since their purchase price is zero, making the division impossible.
Additionally, since property prices fluctuate widely, the first cap rate formula using the current market price is “a more accurate representation as compared to the second one, which uses the fixed value original purchase price,” Investopedia says.
Another approach to calculating the cap rate worth mentioning is the Gordon Model, which is more commonly used to calculate the intrinsic value of a company’s stock price independent of current market conditions. “If you expect NOI to grow each year at a constant rate, then the Gordon Model can turn the growing stream of cash flow into a simple cap rate approximation, using the formula,” according to Property Metrics.
What Constitutes a Good Cap Rate?
Since cap rates—regardless of how they’re calculated—are based on projected estimates of future income, they are subject to high variance. It then becomes important to understand what constitutes a good cap rate for an investment property.
The rate also indicates the duration of time it will take to recover the invested amount in a property. For instance, a property having a cap rate of 10% will take around 10 years for recovering the investment.
“Different cap rates among different properties, or different cap rates across different time horizons on the same property, represent different levels of risk,” according to Investopedia. “A look at the formula indicates that the cap rate value will be higher for properties that generate higher NOI and have a lower valuation, and vice versa.”
What constitutes a good cap rate for a property isn’t a cut-and-dried proposition, Investopedia says
As a hypothetical example, take two properties that are similar in all attributes except for being geographically apart. One is in a posh city center area while the other is on the outskirts of the city.
All things being equal, the first property will generate a higher rental compared to the second one, but this will be partially offset by the higher cost of maintenance and higher taxes. The city center property will have a relatively lower cap rate compared to the second one owing to its significantly higher market value.
This indicates that a lower value cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. Conversely, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.
While the above hypothetical example makes it an easy choice for an investor to go with the property in the city center, real-world scenarios may not be that straightforward. “The investor assessing a property on the basis of the cap rate faces the challenging task of determining the suitable cap rate for a given level of risk,” according to Investopedia.
Cap Rate Components
What are the components of the cap rate, and how do you determine them? Propertymetrics.com puts it this way: “One way to think about the cap rate is that it’s a function of the risk-free rate of return plus some risk premium. In finance, the risk-free rate is the theoretical rate of return of an investment with no risk of financial loss. Of course, in practice, all investments carry even a small amount of risk.”
However, because U.S. bonds are considered a very safe investment, the interest rate on a U.S. Treasury bond is normally used as the risk-free rate. Propertymetrics.com provides a scenario for applying this baseline to property investment:
“Suppose you have $10,000,000 to invest, and 10-year Treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks. What if you were presented with an opportunity to sell your treasuries and instead invest in a Class A office building with multiple tenants? A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate to the yield on the treasury bonds.”
Assuming that the acquisition cap rate on the investment property was 5%, this translates into a risk premium of 2% over the risk-free rate. This 2% risk premium reflects all the additional risk you assume over and above the risk-free treasuries, which considers factors such as:
- Age of the property.
- Creditworthiness of the tenants.
- Diversity of the tenants.
- Length of tenant leases in place.
- Broader supply and demand fundamentals in the market for this particular asset class.
- Underlying economic fundamentals of the region, including population growth, employment growth, and inventory of comparable space on the market.
When you take all of these items and break them out, it’s easy to see their relationship with the risk-free rate and the overall cap rate. “It’s important to note that the actual percentages of each risk factor of a cap rate and ultimately the cap rate itself are subjective and depend on your own business judgment and experience,” cautions Propertymetrics.com.
The Limits of Using Cap Rates to Decide on Acquisitions
As noted previously, Realty Mogul says that although the cap rate is a useful metric when purchasing commercial real estate, it can be misleading if relied upon too heavily. Here are some potential shortcomings of using only the cap rate to judge whether a property is competitively priced:
1. NOI can be calculated in different ways.
“Because the NOI can vary depending upon how it is calculated, the use of cap rates may be inconsistent and unreliable for comparison purposes.”
2. The cap rate reflects a limited period in time.
“The cap rate calculation alone does not tell the story of whether the asset is improving or declining in performance. It merely shows the return or value based upon one 12-month income scenario, which may have already changed since the data was gathered.”
3. The cap rate doesn’t include any mortgage payments.
“The fact that the cap rate does not include the debt financing, which may be as much as 70-80% of the value of the asset, may limit the usefulness of the metric for buyers who plan to use financing.”
4. The cap rate doesn’t reflect expiring leases.
“For example, if two Dollar General stores are both selling for a 6% cap rate, and one has 20 years left on the lease and the other has two years left on the lease, the Cap Rate doesn’t indicate why the two assets have a similar unlevered yield when one has a maturity coming up and the other does not.”
5. The cap rate doesn’t determine whether a property offers a risk-adjusted return.
“While major metropolitan areas like New York, San Francisco, and Los Angeles are known for having assets that sell at low Cap Rates, a low Cap Rate in a tertiary market could either mean that the asset has a long term corporate guaranteed lease (i.e., a Walgreens or other AAA-rated tenants) or that the asset is half empty and therefore not stabilized.”
6. The cap rate assumes a stabilized asset.
“Cap rates are intended to be used to compare stabilized assets to other stabilized assets in a specific market. As a result, a cap rate is not useful for comparing value-add transactions which have below-market rents and/or occupancy.”
According to Investopedia, “The capitalization rate is used to measure the profitability of commercial rental properties. A high cap rate indicates a relatively high income, relative to the size of the initial investment. However, there are also other factors to consider, such as risk and local market dynamics. Investors should be careful to consider a wide range of metrics in addition to the capitalization rate.”