The capitalization rate is one of the most used – and possibly overused – metrics in commercial real estate. Known more commonly as the Cap Rate, the metric is simply a quantified measure of anticipated rate of return on CRE investment properties. Cap Rates correlate with numerous important aspects of a CRE investment including risk and purchase price (inversely) and net operating income (directly). At its most fundamental level, a property’s Cap Rate is designed to predict its ability make profits and provide a return on investment. Understanding the factors that influence the Cap Rate’s ability to do this is crucial, though.
Definition
The most common formula for arriving at a property’s Cap Rate is dividing its Net Operating Income (or EBIT) by its Current Market Value, or Purchase Price.
Thus, if our apartment complex posted a NOI of $100k and was listed for sale at $2,000,000, we would be pushing that property at a Cap Rate of 5%. As mentioned earlier, the Cap Rate relates directly to NOI. Thus, if our NOI increased to $150k and the proposed value remained at $2,000,000, our Cap Rate would also have increased (to 7.5%). The significance of these Cap Rates will be explained shortly, as each signify something different to the potential investor. But this is only beginning to paint the picture of the performance potential of the property.
Often times in deals, Cap Rates are explicitly stated by the current owner/seller, and based upon the factors we will lay out below. However, when the Cap Rates is not explicitly stated, you will need to establish the Implied Cap Rate – that is, the Cap Rate based upon your own calculations. This is done using the formula of NOI (or EBIT) and dividing it by the proposed Purchase Price or estimated Market Value. This is important for at least two reasons. First, providing your own calculations allows you to work through the mechanics behind a Purchase Price and how altering each facet of that calculation impacts your potential purchase. Second, calculating your own Implied Cap Rate heightens your awareness of the assumptions that underlie that value. We will discuss this further below in the role of underwriting, but it is this process that allows a potential buyer to increase the accuracy of their offer.
Even further is the role of the Residual Cap Rate, or Exit Cap Rate. This will be the assumed Cap Rate for your planned disposition of the property. Its another reason why the entry Cap Rate matters, and Residual Cap Rate will be discussed in further detail in a later article.
Another way incorporating the Cap Rate into your property analysis is adapting the Gordon Growth Model, or the Dividend Discount Model. The original application for the GGM/DDM is oriented towards incorporating a more precise time value of money perspective on the intrinsic value of a company’s stock price. This perspective stays independent of the current market landscape, instead focusing on the current value of future dividends. Thus, to accurately ascertain a Cap Rate, we take the expected rate of return and subtract the growth rate (here, NOI increase assumptions). For example, say we are looking at a potential property that has a stated Cap Rate of 8% (typically seen as a conservative number in most markets) with an assumed 3% growth rate each year in NOI. Then the GGM approach to Cap Rate would take 8% minus 3%, for a more “Net” Cap Rate of 5%. As you can see, this also gives us a more conservative lens to compare the Cap Rate during our due diligence process.
CAP RATE VARIABLES
A property’s Cap Rate is going to be impacted by a multitude of factors – each to a varied extent depending upon the deal. The most common factors impacting our calculation of Cap Rates include:
LOCATION
the location of the property is typically the first factor to understand when getting into the Cap Rate process. Vibrant, growing markets will obviously have significantly lower Cap Rates than those in other categories. Which is why understanding one’s market area is the first step to take. Further still, and Specifically within a given market area, a property’s location to highways, cultural centers of activity, employment hubs, public transportation, schools, shopping centers, etc. all impact the direction to which a Cap Rate can rise or fall.
RENT GROWTH
one of the prominent location factors is the area’s past, current, and projected rent growth. This especially comes into play when we incorporate the GGM perspective on understanding a property’s cap rate and current value.
UNEMPLOYMENT
similarly, a location’s unemployment – and overall economic landscape – rate is a significant contributor to local Cap Rate values. As unemployment rates decrease and remain low, Cap Rates of commercial real estate properties usually decrease and remain low. As unemployment rises and the economic landscape dips, Cap Rates tend to trend upwards and remain there until those factors shift – or are projected to shift – again.
ASSET TYPE
Historically, multifamily and industrial buildings have maintained the lowest Cap Rates of all the asset types – though, again, this is still highly-specific to markets, locations, asset classes, etc. Thus, A-Class Office properties in the middle of a Central Business District in thriving market will still have far lower Cap Rates than Multifamily properties in secondary and tertiary markets. Both Office and Retail properties have also experienced significant fluctuations over the last few decades as e-commerce and work-from-home trends have impacted real estate demand and valuations.
ASSET CLASS
Because Cap Rates are also a measure of risk (with lower Cap Rates being perceived as lower risk), A-Class properties will have far lower Cap Rates than those in the B and C classes.
INTEREST RATES
Both inflation and interest rates impact Cap Rates directly, as Cap Rates rise as each of these rise. However, Cap Rates are typically on a more compressed scale than are measures of inflation or interest rates. Thus, a large jump in interest rates or inflation (as we have seen over certain periods in history), will only lead to a few basis point increases in Cap Rates. Still, these are significant macroeconomic factors to incorporate when attempting to ascertain a property’s current Cap Rate for purchase, or to project an Exit Cap Rate for an exit strategy.
AN UNLEVERED VALUE
One important note is that Cap Rates are not just a measure of value at a specific point in time, but these measures are also unlevered performance measures of a property. That is, they are a true unlevered rate of return for investors – a return that is only based upon the NOI and the management of the property. No debt instruments or financing arrangements factor into this value.
Trust the Process
Arriving at your Cap Rate is a critical point in both your journey to acquisition, and in your ability to manage the journey to disposition. Its another reason why investing in commercial real estate, and – specifically – multifamily properties, is a team sport. The process of research and analysis requires multiple teammates and varied perspectives. This process begins with talking with local investors, owners, and brokers to see where local cap rate surveys suggest values are currently. More importantly, getting your hands on comprehensive sales comparison data also provide the insight needed into both perceived value of a property, and in appropriate Cap Rate values.
Due Diligence and Underwriting
At this point, your Cap Rate journey has overlapped with your Underwriting process – one that we will explore in subsequent deep dives in later articles. Fleshing out your NOI and understanding Sales Comps are often steps not fully vetted in the underwriting process, and become essential in ensuring you are walking into a deal with the appropriate Cap Rate. CoStar, Reonomy, RealNex, and broker communication are the most common sources of gaining the essential insight needed to arrive here correctly.
A final role that Cap Rate exploration plays in the process is that of comparison. Constantly and consistently being locked into the process here allows you to understand the pulse of the market, the trends of rent and sales comparables, and to filter through prospective deals with better effectiveness and efficiency.
WEAKNESSES, LIMITATIONS, AND WHY CAP RATES MAY MEAN NOTHING AT ALL
The Cap Rate process is a critical one in the deal journey. However, its role as both a Gold Standard and an End-All-Be-All is vastly overblown, in my opinion. First, the Cap Rate measure is not without its weaknesses and limitations. These include:
DATA QUALITY
the saying Garbage In, Garbage Out applies most readily here. In looking back on all the factors mentioned earlier (and I only included a select few), being able to obtain the accurate, unbiased raw version of each can prove to be difficult. Its another reason why having someone on your team (did I mention that multifamily investing is a team sport?) with the ability to access these data points is imperative. Bad data can begin a ripple of assumptions that will have third-, fourth-, and even fifth-order effects that kill deals down the road.
ASSUMPTIONS
even still, data quality might not be as much of a terminal issue as is the extent to which we fail to assume the appropriate window of error of these data into underwriting assumptions. Bad market factors, out-of-control interest rates, stagnant unemployment rates, etc. all can be mitigated if you are able to build appropriate assumptions and projections off of these into your deal underwriting. The issue becomes when we fail to see the limitations of a Cap Rate and how that impacts our deal – from acquisition to disposition.
Finally (and though calling the Cap Rate meaningless might be slightly exaggerated), I argue that the Cap Rate should only be given meaning to the extent to which you and your underwriting teammates have an accurate comprehension of the data upon which the Cap Rate is built. Are you dealing with unmanipulated, unbiased actual financials and not inflated pro-forma figures that have went through porous property management records, overly motivated sellers, and aggressive broker assumptions?
The fact of the matter is, all of the variables that impact Cap Rates are nearly all estimates and assumptions, and ones that you and your team need to vet thoroughly. And, yes, at some point your Cap Rate may find itself irrelevant during a thorough and comprehensive underwriting analysis that scrutinizes income projections, expense controls, and market trends.
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