The capitalization rate, or cap rate, is a fundamental concept in commercial real estate. It is calculated by dividing a property’s net operating income by its value. Although the formula is simple, the cap rate is often misunderstood and sometimes misused. This article will explore the concept in depth and clarify common misconceptions.
Cap Rate Definition
What is a cap rate? The capitalization rate, typically just called the “cap rate”, is the ratio of Net Operating Income (NOI) to property asset value.
So, for example, if a property recently sold for 1,000,000 and had a stabilized NOI of 100,000, then the cap rate would be 100,000/1,000,000, or 10%.
The cap rate formula can also be re-arranged to solve for value:
Solving for value by dividing a constant annual cash flow by a discount rate is a form of perpetuity calculation. In finance, a perpetuity is a series of cash flows that continue forever, and the present value of a perpetuity can be found by dividing the constant cash flow by a discount rate, or required rate of return.
Although real estate cash flows are not perpetual, the direct capitalization method remains a widely accepted and easy-to-understand valuation technique in the industry.
Cap Rate Example
Let’s take a look at how this works. One way an appraiser can estimate the market value of a property is by using the direct capitalization valuation method.
For example, suppose an appraiser is tasked with estimating the market value of a Class A office building that is expected to produce 980,000 in net operating income next year. The appraiser also has data on the following recently sold comparable properties:
Based on the NOI and recent sale prices for each comparable property, we can estimate an average market-based capitalization rate of 5.7%. Using the subject property’s NOI of 980,000 and the derived capitalization rate of 5.7%, the appraiser could estimate the property’s market value as:
In practice, this value would usually be rounded down to $17,190,000. While this simplified example doesn’t involve the level of detail and rigor of a formal appraisal, it demonstrates the same fundamental direct capitalization technique used by professional appraisers.
Intuition Behind the Cap Rate
What is the cap rate actually telling you? One way to understand the cap rate intuitively is to view it as the percentage return an investor would receive on an all-cash purchase. For example, if a property has a cap rate of 5.7%, an all-cash investment would yield an annual return of 5.7%, not accounting for non-operating costs.
Another way to think about the capitalization rate is to compare it to the earnings yield on a stock, which is calculated by dividing the earnings per share by the stock price. Similarly, the cap rate is determined by dividing the net operating income (NOI) by the property value.
The inverse of the earnings yield is the popular Price to Earnings (P/E) Ratio, while the inverse of the cap rate results in an NOI multiple. This NOI multiple reveals how many years it would take to earn back the purchase price at the expected stabilized NOI.
To invert the cap rate and obtain the NOI multiple, simply divide 1 by the cap rate. For instance, a 5% cap rate results in a value of 1/0.05, or 20 times the NOI. In other words, if you purchase a property for 1,000,000 with an NOI of 50,000, you would earn 5% of the purchase price each year. It would also take 20 years to earn back your original 1,000,000 investment if the NOI remained constant at 50,000 per year.
To visualize this relationship, consider the following chart:
As shown in the chart, capitalization rates and NOI multiples are inversely related. That is to say, as the cap rate goes up, the NOI multiple goes down.
What is a Good Cap Rate?
What’s a good cap rate? The definition of a “good” cap rate depends on your perspective and goals. If you are selling a property, then a lower cap rate is good because it means the value of your property will be higher. On the other hand, if you are buying a property, then a higher cap rate is good because it means your initial investment will be lower.
You might also be trying to find a market-based capitalization rate using recent sales of comparable properties. In this case, a good cap rate is one that is derived from similar properties in the same location. For example, suppose you want to figure out what an office building is worth based on a market-derived cap rate. In this case, a good cap rate is one that is derived from recent office building sales in the same market. A bad cap rate would be one derived from different property types in different markets.
Ultimately, the quality of a cap rate depends on its context and how well it aligns with your investment objectives and market conditions.
When, and When Not, to Use a Cap Rate
The capitalization rate is a common and useful ratio in the commercial real estate industry, and it can be helpful in several scenarios. For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.
Another way cap rates can be helpful is when they form a trend. If you’re looking at cap rate trends over the past few years in a particular submarket, then the trend can give you an indication of where that market is headed. For instance, if capitalization rates are declining, this cap rate compression that means values are being bid up and a market is heating up. Where are values likely to go next year? Looking at historical cap rate data can quickly give you insight into the direction of valuations.
Although capitalization rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.
Components of the Cap Rate
What are the components of the cap rate, and how can they be determined? One way to think about the capitalization rate is that it’s a function of the risk-free rate of return plus some risk premium.
In finance, the risk-free rate is the theoretical rate of return of an investment with no risk of financial loss. Of course, all investments carry some risk in practice. However, since U.S. Treasury bonds are considered to be very safe, the interest rate on a U.S. Treasury bond is normally used as the risk-free rate.
How can we use this concept to determine cap rates?
Suppose you have $10,000,000 to invest, and 10-year treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks.
What if you were presented with an opportunity to sell your treasuries and instead invest in a Class A office building with multiple tenants? A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate to the yield on the treasury bonds.
Suppose the acquisition cap rate on the investment property was 5%. This means that the risk premium over the risk-free rate is 2%. This 2% risk premium reflects all the additional risk you assume over and above the risk-free treasuries, which considers factors such as:
- Age of the property.
- Creditworthiness of the tenants.
- Diversity of the tenants.
- Length of tenant leases in place.
- Broader supply and demand fundamentals in the market for this particular asset class.
- Underlying economic fundamentals of the region including population growth, employment growth, and inventory of comparable space on the market.
When you break down these components of the cap rate, it reveals their relationship with the risk-free rate and the overall capitalization rate. However, the specific percentages assigned to each risk factor, are ultimately subjective and rely on individual business judgment and experience.
Is cashing in your treasuries and investing in an office building at a 5% acquisition cap rate a good decision?
This, of course, depends on how risk-averse you are. An extra 2% yield on your investment may or may not be worth the additional risk inherent in the property. Perhaps you can secure favorable financing terms and using this leverage you could increase your return from 5% to 8%. If you are a more aggressive investor, this might be appealing to you. On the other hand, you might want the safety and security that treasuries provide, and a 3% yield is adequate compensation in exchange for this downside protection.
Band of Investment Method
The above risk-free rate approach is not the only way to think about cap rates. Another popular alternative approach to calculating the capitalization rate is to use the band of investment method. This approach considers the return to both the lender and the equity investors in a deal.
The band of investment method is an application of the weighted average cost of capital formula:
The Weighted Average Cost of Capital (WACC) formula is derived from the fact that property cash flow is equal to the sum of cash flow to debt and equity holders. That means if we know two out of the three variables, then the WACC formula can be used to solve for the unknown third component. In other words, when we know the required returns for lenders and investors, then we can calculate the cap rate.
For example, suppose we survey lenders and learn we can secure a loan for a particular property at an 80% Loan to Value (LTV), amortized over 20 years at 6%. This results in a mortgage constant of 0.0859. Further, suppose that a survey of investors reveals the required return on equity is 15%. This results in a weighted average cap rate calculation of 9.87%:
This band of investment calculation is often used by appraisers when comparable sales data is difficult to find. In cases where comparable sales data is sparse or non-existent, surveys of investors and lenders can provide reliable data to estimate the cap rate using the band of investment methodology.
The Gordon Model
One other approach to calculating the cap rate worth mentioning occurs when NOI isn’t constant but is instead expected to grow at a constant rate. This is the same technique used to value a growing perpetuity. It is also used to value stocks with dividend growth using the dividend discount model, sometimes called the Gordon Model.
If you expect NOI to grow each year at some constant rate, then you can turn this constantly growing stream of cash flows into a simple cap rate approximation.
This formula solves for value, given cash flow, the discount rate, and a constant growth rate. From the definition of the cap rate, we know that value also equals NOI divided by the cap rate.
This means that the capitalization rate can be broken down into two components, the discount rate, and the growth rate. That is, the cap rate is simply the discount rate minus the growth rate.
How can we use this? Suppose we are looking at a building with a stabilized NOI of $100,000 and in our analysis, we expect that the NOI will increase by 1% annually. How can we determine the appropriate cap rate to use? Using the Gordon Model, we can simply take our discount rate and subtract out the annual growth rate. If our discount rate (usually the investor’s required rate of return) is 10%, then the appropriate cap rate to use in this example would be 9%, resulting in a valuation of $1,111,111.
The Gordon Model is a useful concept to know when evaluating properties with growing cash flows. However, it’s not a one-size fit all solution and has several built-in limitations. For example, what if the growth rate equals the discount rate? This would yield an infinite value, which of course is nonsensical. Alternatively, when the growth rate exceeds the discount rate, then the Gordon Model yields a negative valuation, which is also nonsensical.
These built-in limitations don’t render this technique useless, but you do need to be aware of them. Always make sure you understand the assumptions you are making in an analysis and whether they are reasonable or not.
Cap Rate Cheat Sheet
Fill out the quick form below and we’ll email you our free cap rate Excel cheat sheet containing helpful calculations from this article.
The Many Layers of Valuation
Commercial real estate valuation is a multi-layered process and usually begins with simpler tools than the discounted cash flow analysis. The cap rate is one of these simpler tools that should be in your toolkit. The capitalization rate is widely used and can communicate a lot about a property quickly, but it can also exclude many important factors in a valuation, most notably the impact of irregular cash flows.
The solution is to create a multi-period cash flow projection and discounted cash flow analysis to arrive at a more accurate valuation. If you need help building a cash flow projection and running a discounted cash flow analysis, consider giving our commercial real estate analysis software a try.
Conclusion
In this article, we defined the cap rate, walked through an example of how an appraiser uses the capitalization rate to estimate the market value of a property, and then we looked at the intuition behind the calculations. Next we covered what a good cap rate is, when not to use a cap rate, and discussed how to think about the components of the cap rate. Finally, we discussed the band of investment method and Gordon model as practical ways to calculate the capitalization rate when you have limited information or growing cash flows.