Understanding Cap Rates, Return on Cost and Exit Cap Rates
To analyze commercial real estate investments, analysts will put together a spreadsheet (also called a “model”) that takes into consideration all of the numbers associated with a particular project, from the costs associated with the purchase, to the expenses and growth of those expenses during the hold period, to the projected sales price in “X” years. There is a tremendous amount of market data analysis that goes into each projected input, but to quickly view and compare a project, it is helpful to look at all of a project’s high-level investment metrics, to get a quick financial overview of the investment’s target outcome.
In the first part of this series, we looked at how we derive the Internal Rate of Return (IRR), the Target Cash on Cash (CoC), and the Target Equity Multiple (EM). The following provides a few more metrics that real estate investors use to consider the relative risk and return profile of a particular investment in the market. When presenting to our investors a prospective opportunity, some metrics will be denoted as a “Target” metric, which means that the particular metric includes inputs that are speculative and may rely upon the execution of a business plan or other future event to be realized.
Part Two: Market Comparison Metrics
Capitalization Rate (“Cap Rate”) The capitalization rate, or Cap Rate, “indicate[s] the rate of return that is expected to be generated on a real estate investment property.” The cap rate takes the current net operating income and divides it by the sale price of the asset, and in doing so sets a snapshot return on that asset on an unlevered (without debt) basis. Cap rates look at existing, or historic, income and sales, so a cap rate is a backwards-looking indicator and should be looked at with caution when in a rapidly moving market.
For example, if an investor purchased a property for $1,000,000 and the net income of that asset (income minus expenses before debt payments) is $100,000, and the investor purchases the property for all cash, then the investor would achieve a 10% return ($100,000 / $1,000,000 = 10%) on their investment with income that is in-place, and bought the asset at a 10% cap rate. The value of the cap rate metric is really to compare relative values of other stabilized assets across the submarket, meaning stabilized 1980s vintage Class B multifamily assets in a submarket of El Paso may be currently selling for an average cap rate of 6.5%, which provides one metric for an investor who is looking to analyze that property type in the market to determine whether they are getting a good deal or not. A stabilized asset is one that is achieving average market rents and has an average market occupancy, relative to other similar properties in the market.
But it should be remembered that the cap rate is only a quick snapshot and should not be used alone to determine whether an investment is being purchased at a good price. For instance, cap rates are not particularly helpful when buying a value-add asset, as the property is not currently stabilized and therefore is likely being purchased for a below market cap rate due to below market rents and occupancy. For value-add projects it may be better to compare the price per square foot with those of stabilized assets, and then to make sure that the total budget for improvements plus the purchase price divided by the total rentable square feet is still less than those of stabilized assets in the market. That said, if you find an asset that has a higher than market cap rate and a lower than market price per square foot, you may have a good buy on your hands – or there may be some reasons worth looking into that are causing the depressed price.
Return on Cost The Return on Cost metric could be called the cap rate for value-add projects, as it is a forward-looking cap rate that takes into consideration the net operating income, once stabilized, and divides it by the purchase price plus the cost of improvements.² For example, if an asset is generating $50,000 in income today, and is purchased for $1,000,000, the asset is said to have a 5% cap rate. But if $250,000 is put into the asset, and as a result the property will generate $100,000 in net operating income, the return on cost is 8%, or $100,000 divided by $1,250,000. It is easier to see now how buying the asset at a 5% cap, even if the market is selling at a 6% cap rate, doesn’t necessarily make it a bad purchase if the asset isn’t stabilized. If the purchase price, rehab budget, market rents and occupancy all support an actual return on cost of 8%, and the return on cost is higher than the market cap rate, value in the asset has been created. For example, if the property, now stabilized, is sold at the market cap rate of 6% on the $100,000 net income, the cost to buy and rehab may have been $1,250,000, but the “value” is now approximately $1,667,000, or about $417,000 in value created. The Return on Cost is a forward-looking metric, as it requires forecasting the future stabilized income once a business plan has been completed, so it is a target metric that cannot be verified until the sale of the asset.
Exit Cap Rate The Exit Cap Rate is the cap rate of a project that is used to estimate the sale value of an asset at the end of a hold period. Because the exit cap rate is used to determine the estimated sales price, it is a very impactful number when determining the internal rate of return (IRR), that was described in the prior part of this series. Because it is a highly speculative number, it is more of an art than a science, but now with the available market data that is available through data companies, the exit cap rate can be considered relative to 5- or 10-year averages in a market or submarket averages, a spread added to the subject asset’s going in cap rate, a review of cap rates for past sales of the actual subject property, and/or a combination of methodologies that use prudent underwriting standards to consider a reasonable prospective value at sale.
However, the Exit Cap Rate alone cannot predict the future value of an asset, as the Exit Cap Rate will be applied to the future, and as of yet unrealized, net operating income. Even the best underwriters and operators will admit that it is impossible to predict with 100% accuracy what each income and expense input will be over a potential hold period, which could be ten years or more or less. The purpose of underwriting transactions is to attempt to provide a reasonable picture of how the asset may perform using all available information, but the reality is that the outcome will be better, worse, or maybe even close, to expected.
Interested in learning about more metrics that matter? Read Part III , which goes over Loan to Value, Loan to Cost, Debt Yield, Debt Service Coverage Ratio and Loan Constant.
Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.