A property’s cap rate is one of the most fundamental measures of its potential value to investors, yet the measurement is still widely misunderstood. Here we offer a brief explainer of how cap rate is calculated, its limitations, and how you can apply it to your investment decisions.
What is a cap rate?
Let’s say you’re looking at the details and history of two high-value properties and want to purchase one of them. The properties are in the same neighborhood and come with similar price tags attached. There’s only one question that should guide your decision: which of these properties is more likely to produce a greater return on my investment in a shorter period of time? As you likely know already, the metric used to answer that question is capitalization rate.
As a seasoned real estate investor, you’ve probably calculated the capitalization rates of quite a few properties before. You know that it’s calculated by dividing a property’s annual net operating income (NOI) by its cost, and that it’s a good means of comparing the respective values of potential investments. You may have even already recognized cap rate’s advantages over other valuation metrics, including benchmarks like Gross Rent Multiplier (GRM).
But capitalization rate is far from a simple equation — to get an accurate sense of the rate at which your ROI will grow, you’ll need plenty of valid data, good projections, and a healthy understanding of how to factor investment risk into your calculations. Let’s break down some of the factors that determine cap rate, dispel some misconceptions that surround it, and run through some scenarios in which it may and may not be useful.
Cap Rate Formula
To work out the Cap Rate Formula, the calculation at its most basic form is;
Capitalization Rate = Net Operating Income/Current Market Value.
There are many online calculators that you can leverage when calculating the cap rate of your property under consideration;
As discussed earlier, capitalization rate is defined by the formula “NOI divided by property cost or value.” But while determining property value is as easy as checking the listed price, calculating NOI can be difficult and will require plenty of research into market and submarket activity, operating costs, and potential lease options among a whole host of other factors that might affect your investment.
Any decision you make in real estate should be dependent on an understanding of both the current and projected NOI of the properties in question. The property’s seller will usually be able to show you a current NOI, but the projected NOI will have to be based on a series of educated guesses: will you be able to fill all vacancies? Will your tenants be able to reliably pay the rent each month? How much will utilities cost, and can the tenants be incentivized to use them sparingly?
All this is to say that, while the seller may be able to readily supply an NOI figure, or you may be able to find one easily through some surface-level research, net operating income is actually a fairly subjective and difficult thing to measure. For example, sellers may artificially inflate the NOI they give you by collecting large, lump sum payments from tenants, or by deferring routine maintenance work in favor of physical renovations. Unless your source is exceptionally trustworthy, obtaining an accurate NOI, and therefore, an accurate cap rate, involves plenty of diligent research and difficult guesswork.
Calculating Current Market Value
When a property is listed for sale and has a list price attributed, calculating/assigning a number to the current market value is easy.
When this is not available, say if the property is being considered as an off-market acquisition, determining the current market value is another step to consider when calculating the cap rate.
To determine the current value of a property in this instance, sales comparables are used. Sales comparable show what similar properties are selling for to help estimate a current market value of the property under consideration. Sales comps are calculated by contrasting criteria from recently sold properties including geography, sales price, age of building, size and square footage.
Tools such as Reonomy can be used to calculate sales comps on properties.
Why do Cap Rates Fluctuate?
Further complicating the issue of cap rates is the fact that they are subject to market trends at the local, state, and even national level. Property values are affected by local developments, like the addition of new jobs in the area that require the construction of new living spaces, while your NOI can be affected by far-flung world events, like a global conflict that results in increased oil prices. Fiscal regulatory bodies like the Federal Reserve can also indirectly alter cap rates on a local level.
For example, capitalization rates across the net-lease retail sector spiked at the end of 2016 for the first time since the third quarter of 2013, resulting in part from the Fed’s decision to raise interest rates last month. Higher interest rates mean higher costs of maintaining a mortgage for a property, which in turn drives property values down. Since cap rates have an inverse relationship to property value, investors are likely to see better returns on their investments in the next few years, as interest hikes are expected to continue well into 2018.
Given that real estate market conditions for the best they’ve been in some time, investors are likely looking to make purchases now while the odds are in their favor. But as we’ve discussed above, making an educated investment decision in this industry is a long and involved process. With so many variables at play, it’s hard not to second-guess yourself when moving towards a purchase.
Reonomy is working to clear away much of that uncertainty with our commercial property data platform. Instead of working through hours of long equations and phone calls with sellers, investors can simply look up a property’s value, NOI, and cap rate on Reonomy. Look into market trends by filtering your search to similar properties and extrapolating from the sales data you find. Find out everything there is to know about potential costs and issues that might arise, from zoning and tax laws to nearby transportation.
This easy-to-access, high-quality data is precisely what drew Manhattan real estate firm Stonehenge to Reonomy. Their data provider at the time was “deficient, even limiting the number of properties I could search,” says Stav Stern, an Investment Agent at Stonehenge. A demo proved to Stonehenge that Reonomy would offer them everything they needed from a data provider. “It used to be that if an off-market deal happened and we wanted to know the cap rate, it would have taken seven steps to get that information,” he says. “With Reonomy, it only takes one step.”
Which direction are Cap Rates heading?
Like any other financial forecasting, the forecasting of cap rates attracts a range of opinions/predictions. The predictions of CRE professionals could be grounded in a strong belief that market values are heading in a certain direction, and/or that rents are going to increase/decrease. Again, cap rates vary across asset class and geography. A hypothesis for the entire US commercial real estate market can not necessarily be applied to, say industrial cap rates in Georgia. For one opinion on which direction cap rates are heading, we spoke to Michael Bull.
“I think a lot of people aren’t anticipating the cap rate changes that are coming,” he says. “I think cap rates are going to rise higher and faster than the industry is anticipating. Lenders are getting more skittish. When you have funding slowing down and interest rates increasing, you’re changing the industry.” One reason cap rates have remained low in recent years, he noted, is the unprecedented period of low interest rates.
Since the government benchmark used in the commercial real estate market for pricing debt and equity, it stands to reason that the cost of owning properties will rise, and lead to an increase in cap rates — ultimately reducing the value of individual assets for owners and benefitting investors looking to buy. So how can investors and property owners prepare for these changes? “Principals and property owners could see 10% lower property values in two years. In my view, if an owner is thinking about selling in the next four to five years anyway, I’d sell right now.” This is not, as Bull made sure to emphasize, a “doom and gloom” prediction. That said, he believes single-tenant, net lease properties will be the most impacted. He explained that those are the “properties with less ability to raise rent.”
What is a Good Cap Rate?
Since cap rates are not fixed, the measurement of what a good cap rate isn’t either. Evaluating whether the cap rate of a property is good comes down to a measure of relativity. You could measure a cap rate as good against historical market rates or you could argue that a property’s cap rate is performing well considering the current commercial real estate environment. Understanding relative performance can be achieved by looking at the cap rates of comparable properties or market cap rates. Again, the measurement of any cap rate and it’s subsequent performance vary based on the property type and the location of that property. The extent of this can be seen in the graph below, taken from Cushman and Wakefield’s most recent report. In this one example, market cap rates for office space alone varies based on property class type, whether it is suburban/CBD based and whether it is in a major or secondary market.
Cap Rate Alternatives
The Cap Rate Formula is a great back of the envelope calculation, though it is not always the best tool to use. If the property’s net operating income is complex or irregular, with significant variations in cash flow, a discounted cash flow analysis is needed to determine a credible and reliable valuation.
Alternative calculations include the Band of Investment Method and the Gordon Model. The Band of Investment Method considers the return to both the lender and the investors in the deal. It is simply a weighted average of the return on debt and the required return on equity. The Gordon Model is used when you are expecting NOI to grow each year at the same constant rate. The formula is Value = Cash Flow/(Discount Rate – Constant Growth Rate), this means that the cap rate is simply the discount rate minus the growth rate. It is a useful model to consider, though understanding its assumptions are important. For example, if the growth rate outstrips the discount rate, a nonsensical negative value would result.
Cap rates can be tricky to pin down in today’s market, but they don’t have to be. Simplify the process of reviewing, vetting, and purchasing properties with Reonomy.
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