There are two major techniques for measuring rates of return or valuations from real estate investments; ratios, which are simple arithmetic computations, and yields, which discount future income to account for the time value of money. We’ve earlier discussed how loan-to-value ratios can help understand real estate loans. Here we discuss the “cap rate” ratio, one of the more important calculations for valuation purposes.
Ratios generally involve simple arithmetic calculations that, for real estate, relate some level of periodic income to a corresponding asset value. They can be easy to compute and often involve readily available figures. They are not as sophisticated as yield analysis, which is more difficult to perform but takes into account the time value of money, but ratios remain widely used in many situations.
One commonly used ratio is the gross rent multiplier (GRM). This figure shows the relationship between the purchase price of a property to its gross rental income. Gross income is before expenses, whereas net income would be after expenses. Depending on the definition being used, it can be based on either the potential gross income (before vacancies and collection allowances have been subtracted) or effective gross income (net of these factors). Here is an example -- for a property with gross income of $300,000 and a purchase price of $2 million, the calculation would be:
Purchase Price ÷ Gross Income = $2,000,000 ÷ $300,000 = 6.667 GRM
The GRM can initially be useful if one hasn’t yet researched the operating expenses of a property. Ultimately though, the GRM figure’s value is limited, because it fails to take into account the operating expense variations among projects.
The capitalization rate, or “cap rate” (sometimes called the “overall rate of return”), solves this problem by relating the purchase price to the net operating income of the property. It calculates the rate of return on the entire purchase capital, regardless of whether it comes from the equity investor or the mortgage lender. If the property above, which had a gross income of $300,000, had operating expenses of $100,000, then the calculation would be:
Net Operating Income ÷ Purchase Price = $200,000 ÷ $2,000,000 = 10.0% cap rate
The cap rate is a vast improvement over the GRM because it takes into account operating expenses. These expenses – utilities, marketing costs, insurance, maintenance charges, management and leasing fees, and personnel costs – can vary significantly among properties and directly bear on the ultimate value of the property.
The cap rate figure is widely used and is a good ranking device for comparable, unleveraged properties (since it evaluates properties free and clear of any financing) and focuses on the income-producing aspect of comparable properties. It remains important, however, to make sure that truly comparable properties are being analyzed. Comparability means that various properties should be similar in quality, construction, size, age, functionality, location and operating efficiency, as well as in terms of major lease attributes.
The cap rate can give a good indication of competitive market prices, but it has its limitations The question of whether or not a property is a good investment depends on future growth in rents, income, and property values. These aspects of the investment decision must be determined by estimating the future course of the economic base in which the property is located – whether leases, rents, expenses, and major repair expenditures are expected to increase or decrease, and by how much, over the life of the investment. The cap rate also does not take into account the terms of any financing that may be needed in order to afford the total acquisition price.
Cap rates are important market benchmarks that are widely used in the real estate industry. Investors should remember, however, that cap rates are useful only to the extent that a property is being compared to similar ones in the local market. Additionally, since that cap rates do not speak to assumptions about the future, they can’t tell you much about how an investment will ultimately play out. Nevertheless, cap rates are useful contributors to the overall analytical process used in reaching an ultimate investment decision.