Capitalization rate is one of the most misunderstood and misquoted terms in commercial real estate.
What exactly is a cap rate?
Simply, a cap rate is whatever an investor is willing to pay for a dollar of net operating income (NOI). The cap rate, a very common and useful ratio in the commercial real estate industry, can be a powerful tool when figuring out the percentage return an investor will receive on a cash purchase basis.
The basic formula is: Cap Rate = NOI/Market Value.
Seems easy enough right? In the world of commercial real estate valuation, the advantages of understanding cap rates cannot be overstated.
The upside of cap rates is that they can produce a snapshot about a property fairly quickly. The downside of cap rates is that despite their first-glance simplicity, they should not be the singular factor in arriving at any real estate investment decision.
In other words, it’s not that easy.
Commercial real estate valuation is a multi-layered process. Cap rate is most often discussed when considering disposition or acquisition of income producing property. The term has different implications depending on where one is in the property valuation process. For instance, the needle on the cap rate continuum will rise or fall dependent on the following; whether the property is first being appraised, whether the property is newly listed, or whether the valuation is decided at time of purchase or after the purchase.
Cap rate also refers to financial indicators of certain markets, which can be sorted geographically or as property types: multi-family, office, or commercial building. These transactions indicate what has occurred in the market historically. For example, if cap rates of all multi-family transactions in a particular city are calculated using the “after purchase” figures, and tracked over the period of a year, and those rates happen to fall from 10% to 8%, this can mean that higher prices are being paid for the properties. Such a scenario may be a result of several factors; there were multiple buyers, there was more money flooding the market, or from ease of financing. This would indicate a seller’s market, where the price of properties increased without any real increase in property income.
When evaluating properties you need to look at income performance and market values to understand whether you are receiving a good value or not.
Cap rate perspectives during the buying and selling process
In general, buyers desire higher cap rates – meaning more income is produced based on what was paid for the property. Some buyers want to see lower cap rates due to the fact that with lower cap rates the property has the potential to appreciate more over time. On the other hand, sellers like to see lower cap rates – meaning more money was paid to buy the property.
Let’s consider three cap rate perspectives during a real estate transaction:
- A buyer usually tackles the “market value” from two different perspectives: “current” NOI and “proforma” NOI. ”Current cap rate” is figured using the current NOI and the asking price. In this scenario, a buyer typically negotiates the contract amount based upon the current NOI, which most likely will be lower than the projected future income over the next year. Using the current income NOI will ultimately reflect a lower market value, thereby giving the potential buyer cause for offering a lower price (not necessarily a realistic justification). The buyer will more than likely figure the future NOI to determine what the potential rate of return will be once the property is bought.
- After it has been sold the cap rate can be figured using the price paid (market value) and the current NOI. In addition, the cap rate could be figured using the price paid and the projected future income.
- Cap rates are used by appraisers to determine market value. Their appraisal includes market rates obtained by securing recent sales data and also various reports provided by market research companies. Ultimately, they will apply the market cap rate and current NOI with limited projections to determine the market value. The market value appraised may or may not match the current asking/offered contract price. For example, if the seller has arbitrarily set the asking price unrealistically high (by using an inappropriate cap rate and future projected NOI), then the price or contract amount may not be accurate.
Does cap rate reflect return on investment (ROI)?
Many investors assume the “cap rate” is the same as return on investment (ROI). However, this is not necessarily true. 100 % “accurate” cap rates apply ONLY when there is an all cash transaction, AND only if the true NOI after purchase is the same as during the purchase. A change in income and/or expenses can change the return, which means the cap rate at purchase and actual rate of return may not be the same (see examples below). Note that the rate of return (i) is the same for each example (10%) with the cap rate (R) varying for each one.
It is not uncommon to have investors demand, “Find me a 15 percent cap rate!” Really. I have to ask if they know what they are talking about because a low cap rate indicates that NOI increases the growth in value, potentially accelerating faster than a higher cap rate might. The higher rate points to the fact that as the NOI grows the market value increase will be less than a lower cap rate. For example, with an NOI of $100,000 and a cap rate of 5%, the NOI increases by $10,000, so the market value increases by $200,000. The same property with a 15% cap rate will only increase in value by $66,666!
Do you still want those super high cap rates?
Generally, the cap rate for the property from an appraisal will stay the same – a 5% cap rate property one year later will stay a 5% cap rate property when an appraiser determines its market value. An exception would be if the cap rates for the market area or type of property either increased or decreased on average for that period.
Cap rates and “multiples”
The amount paid for a property is the 1-year expected NOI, times a “multiple.” The higher the cap rate, the lower the multiple; the lower the cap rate, the higher the multiple. The mathematical formula is 100/cap rate percentage. Accordingly, an 8% cap rate would have a 12.5 multiple. A 5% cap rate would have a 20 multiple. Therefore, when buying a property with a 5% cap rate the amount paid for the property would be the NOI x 20. For an 8% cap rate, the formula is NOI x 12.5.
With a higher cap rate you realize more dollars in return (versus what you might get in NOI) and generally not as much appreciation of value is expected. Conversely, a lower cap rate relates to a higher ratio of how much was paid (to the amount of expected NOI), whereby more market value appreciation is anticipated.
How cap rates relate to risk
A low cap rate generally relates to more risk when you count having to dish out more money up front in order to realize future gains. A higher cap rate, on the other hand, means laying out less initial capital. However, while the idea of paying less up front is alluring, there are other factors to contemplate. For example, the higher cap rate properties, while attractive at first blush, may be older, have less stable tenants, higher maintenance issues, etc.
Consequently, the lower initial investment may equate to higher future risk.
To explain further where a higher cap rate may be a gamble, let’s consider a bond purchase. 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.
A bond, generally considered the safest investment of all, can yield returns of 2-3%. If you purchase a property with a cap rate of 6% the difference between the 6% and 3% yield can be considered the additional risk premium you are willing to take for gambling on this investment (a commercial building versus a bond). It’s fairly easy now to imagine the benefit/risk ratio of purchasing a building with a 5% cap rate versus purchasing a building with a 15-20% cap rate.
Theoretically, any percentage points over the current bond rate of return can be considered what is needed to cover risk factors discussed earlier; age of property, loss of vacancy, maintenance issues, and other associated risks. Each additional risk, such as the property’s age could be assigned a percentage value, for example, 1% of value. When one combines all of the risk premium percentage points to the current bond rate, a suitable cap rate could be calculated for the property.
Which is more important: cap rate or rate of return?
Virtually all investments carry risks. To borrow a few words from Warren Buffet, “Risk comes from not knowing what you’re doing.”
The key to minimizing risks is to recognize your comfort level and act accordingly. While understanding cap rates is one component in the complex process of forecasting rates of return on your investment, this specific knowledge carries only so much weight.
If one does not take the time to analyze the market and take the time to fully understand the intricacies of real estate investing, the risks will undoubtedly be higher. Every investor should understand what is most important to him or her; rate of return, stability, risk levels, etc. To minimize risks, create an investment strategy with plenty of tools that you can use to adapt to the changing market.
In closing, perhaps the take away is this: Cap rates should only be used to understand a property’s value at a glance, and should not be the sole determining factor for market value or what the true rate of return is.