CRE 101: What is a Cap Rate? (Part 1)
Commercial Real Estate
A property’s capitalization rate, or “cap rate”, is a snapshot in time of a commercial real estate asset’s return.¹ The cap rate is determined by taking the property’s net operating income (the gross income less expenses) and dividing it by the value of the asset.² Commercial real estate is an investment type, so the return is a reflection of the risk and the quality of the investment.³ The cap rate does not take into consideration a mortgage, if any, and is most useful in a market where sales occur often and buyers can use comparable sales of stabilized assets to compare and determine if the price being offered is reasonable, relative to other sales.⁴
Cap rates are commonly used by real estate professionals because they are a quick and easy way to calculate value,⁵ but they are not without their shortcomings. The following 4-part series will explore when to use cap rates, cap rate limitations, why cap rates are not used for value-add acquisitions, and what a “good” cap rate is.
Using an asset’s cap rate may be helpful when looking to value an asset at purchase and to compare that asset to the sales of other similar assets in the market. For example, a buyer is looking at an apartment building that has 10 units each earning $2000 a month in rent; this means the property is grossing $20,000 a month or $240,000 in income a year. The buyer then subtracts the property’s expenses, which are $96,000, and the result is a net operating income (NOI) of $144,000. If the buyer knows the market is a “7 cap market” (i.e., a 7% capitalization rate), the buyer can divide the $144,000 by 7% and determine that a reasonable purchase price to offer the seller is $2,057,143. Flip this around, and if the seller is marketing the property for a $2,060,000 sale price, and the buyer requests and receives a 12 month trailing profit and loss statement that shows $144,000 in net operating income, the buyer can determine that the asset is being sold at a 7 cap rate ($144,000 / $2,060,000) and compare it to other similar properties to determine if the sale price is reasonable.
The cap rate is an asset’s unlevered (no mortgage) return, and a reflection of an asset’s relative risk. If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment. Cap rates are seen as a measure of risk and return, a “low” cap rate of 3-5% would mean the asset is lower risk and higher value; a “higher” cap rate of 8-10% reflects a lower price, higher risk and higher return.⁶
The cap rate is a metric that a buyer can use to compare the price of an asset in the market with other similar properties that have sold in the last 6 months (or longer) and to track trends in the market over set periods of time. Buyers use the cap rate as a way to determine if they are getting a deal on a property they are looking to purchase by comparing it to the prior sales prices of other similar properties in the market. Brokers and sellers use cap rates as a sales tool to attract buyers to the asset by showing transparently how they priced the asset and to entice interested parties with an asset’s potential yield.
Cap rates can also be used to quickly estimate a property’s value when considering a refinance. If a property owner wants to consider a refinance, they may need an estimated value to determine what potential loan amount the property supports using the lender’s loan to value (LTV) metric. Once the estimated value is calculated, the owner can determine whether a refinance is possible, or even worth it.
Some buyers use future estimated cap rates to model the projected return of a property before it is purchased. A financial “model” is put together in excel to determine a project’s projected return profile and to see if it meets the buyer’s return targets. The model uses the purchase price, closing costs, the senior debt, projected income and expenses with growth over the anticipated hold period, as well as a projected exit price and potential profit. In order for a buyer to complete the data inputs in a model and reach a projected internal rate of return (IRR), many unknown figures must be assumed using available market data. For example, Axiometrics, a provider for multifamily data, issues reports that show what the projected market rent growth is in a submarket so buyers can incorporate those rent growth numbers into their model.⁷ CoStar, another commercial real estate data provider, offers historic cap rates for markets and submarkets which helps buyers determine reasonable cap rates for that market when estimating the exit price of the asset at the end of the projected hold period.⁸
While Cap Rates are a useful metric, they should not be relied upon solely when analyzing an investment property,⁹ and have certain shortcomings that will be explored in part two of this series. Part three of the series will describe why cap rates are inappropriate for value-add transactions, and the final piece in the series will answer the question ‘what should my target cap rate be?’.
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.
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