The Capitalization Rate or “Cap Rate” is the most commonly used concept to measure real estate investments and is usually the most misunderstood. It measures the property’s performance with financing and will tell you how much you will make on an investment if you paid cash for it. It is the best way to equalize the playing field when measuring one property value against another.
What is a good cap rate for an investment property?
Typically, the answer is that it depends. A property’s cap rate is as simple as the annual Net Operating Income (NOI) divided by the purchase price. It represents the annual return on an asset if all other things are equal. With one of the factors being income, often the cap rates are based on the projected estimate of future income.
Ideally, different cap rates between properties will indicate different levels of risk so a lower cap rate would be a lower risk and a higher cap rate would imply more risk. The challenge is for you to determine the right cap rate given how risky the deal is.
What does this mean?
Cap rate measures what a property’s yield will be in a one-year span. It is an easy way to compare one property against another without taking the debt of an asset into account or to provide the natural, unlevered rate of return.
You could also view it as a way to measure the risk of a deal. It judges with all things being equal, the properties that are older and have few creditworthy tenants, and possibly pose a higher risk, it would be lower in price and result in a higher cap rate. Risk premiums could also include the condition of the property, location, diverse tenants and the length of leases in place and impact the property values and the cap rate.
When is Cap rate used?
Commercial real estate is complex and values can seem rather hard to calculate. Cap rates give you a comparative tool that looks to view potential investment properties in a more side by side analysis. Buyers and sellers can count on cap rates to confidently evaluate fair price and determine trends in a market.
Calculating the Cap Rate
Several core factors should be included to determine cap rate when analyzing a potential investment property such as location, asset type, and prevailing interest rate environment.
The location is everything. The value of real estate property is only driven by demand and demand is largely driven by location.
There are 381 Metropolitan Statistical Areas (MSAs) in the United States. This is also used interchangeably by real estate investors with terms such as “metro area” and “market”. With each market comes its own set of underlying economic fundamentals such as employment rate, primary industry, education and median household income and these have a huge impact on risk and therefore cap rates.
What this means is that even with a 5% lower annual return in Los Angeles vs. the same asset in Memphis investors perceive Los Angeles less risky. The Los Angeles market is wealthier, larger and better educated and makes a more dynamic local economy which typically makes the demand for office space stronger in the long-term, the market fundamentals.
Within the Market
Home prices are typically higher the closer a residence is to downtown in major US cities. The same is true with commercial real estate. When prices are higher, cap rates are lower and investors are willing to pay more for Central Business District (CBD) assets because the perceived risk is lower than in the suburbs. This is because there is only so much land available in the CBD which gives a natural demand because it’s closer to other businesses and infrastructures such as dining options, nightlife, grocery stores, etc as well as transportation.
Cap rates vary greatly within the commercial real estate in a market by asset type as it relates to perceived risk. Asset types include Multifamily, Office, Industrial, Retail, and Hotel. Multifamily housing consistently have the lowest cap rates in the market because they have lower risk relative to other assets. This is because people always need a place to live no matter what the economy looks like. In larger apartment buildings, even when a few tenants don’t pay it does not destroy a property’s cash flow because one individual unit is a small percentage of the income. Contrast this with an office building that has one tenant. If that tenant goes out of business or moves there is typically a loss of money before a new building can be found which may be difficult in a recession.
The least intuitive part of cap rates is the relationship with interest rates. Cap rates can shift without a change in a property but solely based on changes in interest rates. Real estate property investment is largely driven by the amount of debt borrowed to purchase property and the spread between the interest rate and the cap rate. The best way to make sense of it is if you think of the interest rate as the cost of money with the cap rate as the value of that same money when invested into the property.
Remember that adjusted interest rates (like those set by the Federal Reserve) can artificially impact cap
rates. What that means is with no underlying changes to the asset or risk in the deal the cap rate can
fluctuate .5-1.0% because of the interest rate change. It may not seem like a lot but it can heavily impact
a property’s value.
What Cap Rate looks like in action
An example of all this would be to evaluate a project to invest in that costs $10 million with an annual NOI of $700,000. The building next door is relatively similar with the same square footage and is generating an NOI of $300,000 with the same $10 million price tag.
This tells you that the first one is the one you want to buy.
The NOI or the value of the property can change and cause the cap rate of a property to change as well. Market demand and interest rates can impact the property’s value. This can cause the cap rate for a property to go up and down without any physical changes to the income amount (NOI).
Is there a time to avoid using Cap Rates?
When used correctly cap rates are an important tool for valuation but cap rate should not be used by itself to decide on an investment. Cap rate does not apply if you are evaluating a fix-and-flip or short-term investment that you are planning to quickly sell. In these cases, you will not hold the property to generate an income from rent and that negates the cap rate measurement.
Also, note that cap rate is not the same as cash-on-cash return. Cash-on-cash is determined by the cash flow amount after debt service is paid for or mortgage payments are divided by the total dollar amount of cash invested. Both of these tools are useful to evaluate the potential profit of an investment, cap rate does not take into account the debt on a property.
What this means in today’s economy
We have a low-interest rate environment right now and cap rates for commercial real estate are at an all-time low in nearly every asset class. The Federal Reserve’s policy decisions are the main reason interests rates are low and not necessarily market-driven reasons. Since 2008 and the collapse that happened in the US there has been an unprecedented run up in real estate value, especially in San Francisco and New York markets where cap rates are down in the low single digits right now. Because cap rates are this low, property values are at an all-time high, which makes it a challenge to find new investments that most would consider a relatively good value.
To sum it up
The cap rate is a comp metric that is most valuable when used to compare very similar subject properties in location, asset type and value at the same point in time and a ‘good’ cap rate is totally dependent on these things. Because of this macro-economic environment, investors need to understand, more than ever, the benefits and drawbacks when they use cap rates to choose investment opportunities to pursue. Some are simply overpriced relative market comps. Smart investors are willing to ask hard questions and make sure they are adequately compensated for the risk they are taking on.