Whether you are an industry professional, a part-time investor or a casual observer of real estate markets; you have likely heard of cap rates. In this article we will explore how they are constructed, how they are used and some helpful ways to conceptualize them. This will better arm you in your real estate analysis.
Cap Rate Construction
What is a “cap rate”? Cap Rate is short for capitalization rate and is the ratio of NOI to Value:
Cap Rate = NOI / Value
The NOI is Net Operating Income, of course, and is a measure of the profitability of operating a real estate investment. NOI does not reflect the impact of debt service (mortgage payments) or capital expenditures. While you may think this makes the line item LESS useful, it actually allows for consistent comparison of profitability of operation and not the terms of your debt or the improvements you chose to make as an owner.
Value is the value of the investment. Direct real estate, being an illiquid and infrequently traded asset class, only truly reveals its value at the moment it is traded under fair market conditions through an arm’s length transaction by prudent and knowledgeable actors. So…the value of an asset is the value at the time of sale or the most probable price when sold under those conditions.
What may not be obvious at first glance is the sheer number of methods, types and derivations that exist of these two simple variables – NOI and Value.
- Is NOI stabilized?
- Forward Looking?
- Annualized from a monthly amount?
- Adjusted for a down month?
- What about value?
- Contract Price?
- “All-in” Price after estimated closing costs?
- After necessary capital improvements?
As with all things in real estate analysis (and life?) if there is confusion…ask. There is no governing convention for all scenarios, and it is best to clarify.
We have worked with some extremely sophisticated private equity firms and there is never any shame in saying: “wait a minute, are we talking pro-forma or actual here?”
Cap Rates as a Valuation Tool
The most common use and conception of cap rates are as a simple valuation tool. Simply take the NOI and divide it by an appropriate cap rate for the property type, location, and class. Recent and historical transaction data will provide you with comparison properties to determine what is an appropriate range for the cap rate.
This is an extremely useful (if over-used) form of analysis and any analyst worth her salt will be able to throw out a range of cap rates applicable to any property at any time (especially in casual conversation over beers).
But it is advised that you dig into the convention used. That will determine the true meaning and usefulness of the value derived. For example, like properties may be trading off a 6 cap but the market tends to be optimistic and assuming unreasonable rental assumptions that will not materialize. So, values are a bit inflated and your more conservative approach justifies 6.2 – 6.4
Cap Rates as the Price Point of Capital Markets
Capitalization rates are the price point of market demand and market supply of capital. We don’t need to revisit complicated economic theory to explain this point. It is the same “supply and demand determines price” concept that we are familiar with. A higher demand for capital (for investments) shifts the demand curve to the right and raises the cap rate. Greater supply of capital, in the markets, shifts the supply curve to the right and decreases the cap rate. In other words – more money needed for investment properties puts the pressure on sellers needing capital and lowers the price (higher cap rate) while more money available for investment properties allows for more competitive bidding and raises the price (lower cap rate). A related term is “cap rate compression” – the phenomenon of an abundance of capital for investment real estate, resulting in raising prices above intrinsic values.
Cap Rates as a Profitability Ratio
The cap rate, after all is the desired rate of NOI for a given investment value. This is the third and last conception of cap rates in real estate investment analysis. It is the rate of the NOI you get for a given investment value. Given the property specific risk characteristics on an investment – NOI, as a percentage of the purchase, will be bought. It is the anticipated cashflow that you are buying in investment real estate.
[This is akin to the Gordon Growth Model or Dividend Discount Model for those of you coming from a stock/equities background]
- There are many ways to quote cap rates and clarification should be sought on the component metrics for meaningful analysis.
- Cap rates are a useful “back of the envelope” valuation tool that equates the profitability of real estate to the value.
- Cap rates are a price point and an indication of the supply and demand factors of investment markets.
- Cap rates are measure of acceptable profitability for a given property.
As a caveat – volumes of pages could be written about capitalization rates and much of that information requires or assumes a sound background in finance and economic theory. I hope the above will elicit discussion and introduce various ways that cap rates are conceptualized by industry professionals.
Investopedia – What Is A Cap Rate
CBRE – 2021 Cap Rate Survey