Understanding Cap Rate

What is Cap Rate?

Every commercial investment is valued to a great extent by its Capitalization Rate (or “Cap Rate”)Therefore, it’s vital that every investor know what it means and how it is used by different players in the deal.

The “Cap Rate” (or Capitalization Rate) of a property is essentially the expected rate of return on a real estate valuation.  But that said, its calculation, its dynamics, its use, and its meaning can vary – in others, its meaning is one of those things that falls under the catch-all “it depends on the context.”

Different stakeholders use the cap rate to understand an investment from their point of view, risk and opportunity.

• Banks use the Cap Rate (at least their variation of it) when deciding the value of a property so that they can decide how much funding they are willing to put up for the deal.  They may also make adjustments to the Cap Rate projections in order to put extra margin in their financing to cover risk from their point of view.
• Sponsoring partners use the Cap Rate (their variation of it) as a simple measure of their performance in managing the asset.
• Passive investors use the projected Cap Rates to help them decide if a deal will produce returns in keeping with their investment goals and to determine if the sponsors have a conservative or risky estimate in their projections of performance.

So, the Cap Rate is important to understand because everyone in a deal uses it for their own form of analysis and its important to know how the other players are looking at it.

“Capitalization rate is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost or alternatively its current market value.”
https://en.wikipedia.org/wiki/Capitalization_rate

Upfront you may be asking, is a high cap rate better than a low cap rate – well, it depends on if you own a deal or want to buy one and fix it up – so, again, it depends.

So let me outline the big picture first, and then we’ll wade through the details.  I’ll cover this topic in 4 steps:

1. The simple explanation of the cap rate – the mathematical equation and one of its alternative expressions
2. The dynamics of the cap rate – the math in motion
3. How is Cap Rate used – the math applied
4. The different perspectives based on how one would use the cap rate – the who are you and why would you care, or the applied domain set

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1. The simple explanation of the cap rate.

The primary equation for determining the cap rate is expressed as:

CapRate = (Net operating income {link} )/(Current market value of the property) (E1)

or expressed another way:

Market Value = NOI / CapRate (E1′)

Ex.  A property valued at $1 million producing an annual NOI of $80k could be measured as an 8% cap rate

But nothing is every simple.  There is always an “it depends” lurking around the corner.

With solving multi-variable equations, its best if one seeks to understand each variable separately to better understand its impact on the whole equation.  Once one does that, then one can simplify it and solve it to determine if a prospective deal is right for them.  One investor’s answer will vary from anothers – kinda like grading on a curve, only its your curve – a curve that depends (another “it depends”) on your investment goals, your comfort with risk, and your comfort with who is running the deal (managers etc.).

Here is a list of some of the most important variables one needs to consider.

a) The variability in what “current market value” means, and w ho is determining that?

b) The variables in NOI

c) The variable of one’s position in the dead

d) And, the variable on where one is in the acquisition cycle

(a) Current Market Value for a property can vary due to

• its “asset class” {link}
• its location
• geo, noise, …
• its condition
• its amenities
• its ease of access
• its age and type of construction
• its safety
• fenced in, security cameras, etc.
• its surrounding market and submarkets
• its ability to stay (near) fully leased
• its surrounding competition and their rent rates
• its prospective economic potential (or past)
• and other “it depends”

So basically, how is is the property in review positioned within the market around it.  (kinda like a single-family residence is valued relative to its own neighborhood)

(b) NOI {link} has variability in that it can be impacted by both increasing gross income and by decreasing expenses.  Since this is a whole topic within itself it has an article of its own.

(c) One’s position in a deal may be:- as a passive investor {link}- as a sponsor {link}- as a key principal {link}- as a banker

(d) What stage of acquisition ?- looking for a deal, pre-closing- new acquisition- stabalized {link} property- selling, 1031 exchanging, refinancing

 2. Dynamics of Cap Rate – The Math in Motion

First, some of the obvious from the equation:

a) If a property’s market value (MV) increases while NOI is constant then its Cap Rate (CR) declines

b) If MV is constant while NOI increases then CR increases

c) If MV decreases while NOI is constant then CR increases

d) If MV and NOI both change, then specifics are needed to see if CR goes up or down

Finally, the less obvious:

Cap rate can be used to factor risk into a deal.  For example, if a bank is considering loaning a sponsor funds then he/she can obviously change the Loan to Value (LTV) rate they are willing to lend, but they can also determine their own cap rate for the specific property in question.  If the property has more risk in it, then they will set the cap rate slightly higher (and thus lower the value of the property over all since they are looking at the NOI as a key input to their math).  Or if the property is in a great location and has good upside, they may lower their cap rate (thus increasing the value of the property given the current NOI as input).  Sound weird how that happens?  Consider th examples in the next section (3).

 3. How is Cap Rate used – the math applied

If a property being considered for purchase is in a good part of town, like a newly revitalized city center area, then a loan officer may recognize the property’s opportunity to gain value and may be willing to lend the sponsor more funds (while keeping the LTV the same).  Based on the current NOI (let’s say this is an existing property being sold to the sponsor), then using the equation MV = NOI/CR, lowering the cap rate on a fixed NOI actually says the MV is higher – if the MV is higher, then the amount you can borrow is higher.  But it also acknowledges that there is risk in the deal but it hopes for the upside.  As you’ve heard before, “higher risk, higher potential gains” (or higher losses too!).

Another example: suppose you wish to sell the property – having a lower Cap Rate when you sell may mean you get more money when it is sold (all other things being the same).  If that sounds weird, just try a few examples:

a) if your NOI is 100,000 and the CR is 10%, then the valuation of the property is 1,000,000

b) if your NOI is 100,000 and the CR is  8%, then the valuation of the property is 1,250,000

Translated this means a lower CR means the relative value of a property is higher in the view of the lenders – and as discussed before, it may because of the current market conditions, the neighborhood, opportunity for growth, etc. Yet, in the view of a sponsor, a higher cap rate during operations means one is receiving a higher cash flow relative to the current market value of the property.  Ok, that may have messed with your mind.  Just remember the equation, and use it according to your perspective and situation in a deal.

4. The different perspectives based on how one would use the cap rate – the “who are you?” and “why would you care?”

So, what are your goals?

If ya’ll (as a group of sponsors and passive investors) plan to take a depreciated property and fix it up as in a value play {link}, where ya’ll plan to increase the NOI, then ya’ll will look at the current CR and compare it to the surrounding market’s CR for similar properties.  If nearby properties have an NOI of 100,000 and their cap rate is 8% (thus MV is 1.25 mil), and if the property ya’ll are evaluating will be in the same class (A, B, C, D) once it is fixed up, and it is being offered for 1,000,000 with an NOI of 100,000 (which is a 10% CR), and ya’ll believe you can fix it up and raise the NOI 10% to 110,000, then ya’ll will have (at an 8% CR in the market because your property has now been renovated and is comparable to the others) ya’ll will have a property (once fixed up) valued at 1,375,000.

If ya’ll’s LTV on the purchase was 75% (downpayment of 250,000 plus 100,000 rehab expenses – keeping it simple: ya’ll have 375,000 in the deal as a group of investors) then the deal could likely be refinanced in 3 years or so at 80% LTV (hopefully, since it all pretty now) which will provide nearly 350,000 of equity back to ya’ll as the investors.  This translates to a 93% return of capital in 3 years – or about 31% IRR.  Oh, did I mention, that ya’ll still own the property and are continuing to receive quarterly distributions?

If ya’ll were receiving an 8% CoC return in the 3rd year (or 8,800 a year), now that ya’ll have all but 25,000 of your money back, 8,800/25,000 is now a 35% annualized return on what you have left in the deal!  In reality, after refinancing, the monthly mortgage payment expenses will go up and so the distributions will go down a bit.  But still, 7,000/25,000 is 28% return on ya’ll’s remaining capital in the deal.  Now, them are chickens you can count!  AND, ya’ll can now go invest your 350,000 you just got back, into the next deal.

AND, ya’ll don’t have to pay taxes on the 350,000 because its technically “loan” money (did I mention however that the tenants are still paying the mortgage?).  Oh, and then there are tax advantages due to depreciation and mortgage pay down from the rent collections – but that’s material for other articles for later. Note however, that value plays usually don’t have CoC distributions while the rehab is going on – or at least, they will be fairly small.

If ya’ll are simply looking for a yield play {link} then the math all works the same, but the increase in NOI and the decrease in CR will not be so dramatic.  Yield plays are designed to give cash flow to an investor.  There will still be up-side if the property is refinanced or sold, but it typically isn’t as dramatic as a value play.  Yield plays usually come with less risk as well.  Yield plays catter to those who need regular income now – like, in retirement days.

If one is evaluating a property’s performance (as in a loan officer of a bank) then he/she will be working with risk primarily.  And this web site isn’t designed to teach banking.  Just know that the bank wants to cover its own risk and still make a profit.

 

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Conclusion?

Recognize what your role is in an acquisition {potential passive, sponsor, …}

• Determine what your purpose is in evaluation the investment {performance, potential, …}
• Consider other aspects of the deal to get a bigger picture on the whole- such as performas, overall IRR {link}
• Perhaps consult with others who are doing the same *** caveate – keep PPMs private … ask your sponsor questions
• Then decide what you are going to do about the deal/opportunity