Capitalization rate

Summary

Capitalization rate (or "cap rate") is a real estate valuation measure used to compare different real estate investments.

The role of the cap rate in real estate is to help investors analyze the potential value of a property, and the associated risk.[1] There are many variations used by real estate practitioners,[2] but the cap rate is generally calculated as the ratio between the stabilized net operating income (NOI) of a real estate asset and its current market value.[3] The variance in the cap rate per method used depends on the timing of the rental and ancillary income, as well as whether the market value of the property or the purchase price was used.[4]

The entry cap rate measures the rate of return on an investment property based on its estimated net operating income (NOI) and the current market value of the property. It's calculated by dividing the NOI by the current market value of the property.

The entry cap rate, or "initial yield", is mostly used as a preliminary screening tool in commercial real estate to help investors compare different investment opportunities, and allocate capital to the property with the most attractive risk-return trade-off. In other words, the investor is considering to purchase or acquire a property on the date of analyses.

Basic cap rate formula edit

The cap rate is calculated by dividing the annual net operating income (NOI) by the current market value of the property.[5]

 

There are times at which investors calculate the cap rate differently, such as using the "purchase price" or "asking price" instead in the denominator.

However, the reason for the switch being acceptable is that the purchase price must be priced near the current market value. Otherwise, the real estate investor must be paying a significant premium and likely to incur a loss on the investment if the acquisition price is substantially greater than the fair market value (FMV).[6] In instances where the purchase or market value is unknown, investors can determine the capitalization rate using a different equation based upon historical risk premiums,[7] as follows:

 

Cap rate explanatory examples edit

For example, if a building is purchased at a $1,000,000 sale price and the property is expected to produce $100,000 in net operating income (NOI) at stabilization, the cap rate is 10%.

  • $100,000/ $1,000,000 = 0.10 = 10%

The net operating income (NOI) is the income remaining after all direct property expenses – fixed costs and variable costs – are subtracted from the effective gross income (EGI). The building's capitalization rate is 10% percent, or in other words, one-tenth of the building's cost is paid by the net proceeds earned in the year.

If the owner bought the building twenty years ago for $200,000 that is now worth $400,000, his cap rate is:

  • $100,000/ $400,000 = 0.25 = 25%.

The investor must take into account the opportunity cost of keeping their money tied up in this investment. By keeping this building, they are losing the opportunity of investing $400,000 (by selling the building at its market value and investing the proceeds).

For that reason, the current value of the investment, not the actual initial investment, should be used in the cap rate calculation. Most real estate transactions are financed using borrowed capital, such as mortage loans. Thus, for the owner of the building who bought it twenty years ago for $200,000, the real cap rate is twenty-five percent, not fifty percent, and they have $400,000 invested, not $200,000.

As another example of why the current value should be used, consider the case of a building that is given away (as an inheritance or charitable gift). The new owner divides the annual net income by the initial cost, say,

  • income/cost = $100,000/ 0 → Undefined

Anybody who invests any amount of money at an undefined rate of return very quickly has an undefined percent return on his investment, or an error message in Excel.

From our illustrative exercise, we can observe the positive increase in the value of the real estate asset. However, the pace of growth in rental income and ancillary income should increase at the same rate for the same cap rate to be maintained.

Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years.

Note that a real estate appraisal in the U.S. uses net operating income (NOI). Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income.

An investor views his money as a "capital asset". As such, he expects his money to produce more money. Taking into account risk and how much interest is available on investments in other assets, an investor arrives at a personal rate of return he expects from his money. This is the cap rate he expects. If an apartment building is offered to him for $100,000, and he expects to make at least 8 percent on his real estate investments, then he would multiply the $100,000 investment by 8% and determine that if the apartments will generate $8,000, or more, a year, after operating expenses, then the apartment building is a viable investment to pursue.

Cap rate in property valuation edit

In real estate investment, real property is often valued in accordance to a pro forma capitalization rate estimate. The formula to calculate the capital cost (or asset price) is shown below:

  • Capital Cost (asset price) = Net Operating Income/ Capitalization Rate

For example, in valuing the projected sale price of an apartment building that produces a net operating income of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or the price paid to own it) is $142,857 (= $10,000/ .07).

The real estate appraisal referred to is known as the direct capitalization method,[8] and is commonly used for valuing income generating property.

One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to re-build the structure in addition to the cost of the land and capitalization rates).

Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income properties, are usually compared to ensure that estimated revenue is being properly valued.

Net operating income (NOI) edit

The capitalization rate is calculated using a measure of cash flow called net operating income (NOI), as opposed to net income. Generally, NOI is defined as income (earnings) before depreciation and interest expenses:

  • Net Operating Income (NOI) = (Net Operating Income) − (Direct Operating Expenses)

It is critical to ensure that non-operating expenses, such as tax write-offs. depreciation, and mortgage interest, are not factored into NOI.[9] But one common misconception is that NOI excludes taxes entirely. The NOI of a property accounts for all direct operating expenses, which includes property taxes, as such provisions are part of the business model.

Levered pre-tax cash flow edit

Moreover, the annual debt service is the sum of a property's interest cost and principal amortization. By subtracting the net operating income (NOI) by the debt service, the result is levered pre-tax cash flow.

  • Levered Pre-Tax Cash Flow = NOI − (Debt Service)

Depreciation in the tax and accounting sense is excluded from the valuation of the asset, because it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition, however, estimated annual maintenance expenses or capital expenditures will be included in the non-interest expenses. Although NOI is the generally accepted figure used for calculating cap rates (financing and depreciation are ignored), this is often referred to under various terms, including simply income.

Use-cases of cap rate edit

Capitalization rates are a tool for investors to use for estimating the value of a property based on its net operating income (NOI). For example, if a real estate investment provides $160,000 a year in NOI and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $2,000,000 because $160,000 divided by 8% (0.08) equals $2,000,000.

A comparatively higher cap rate for a property would indicate greater risk associated with the investment (decreasing demand for the product, and the corresponding value), and a comparatively lower cap rate for a property might indicate less risk (increased demand for the product). Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality and location of property, and general volatility of the market.

Factors of determination edit

Cap rates are determined by three major factors; the opportunity cost of capital, growth expectations, and risk.[10]

Commercial real estate investments compete with other assets (e.g. stocks and bonds) for investment dollars.

  • If the opportunity cost of capital is too high, investors will use their capital to purchase other assets and the resulting decreased demand will drive prices down and cap rates up.
  • If the inverse is true, cap rates will be driven down by the increased demand stemming from lower opportunity cost of capital.

The primary source of income in commercial real estate is rent. Rental rates are driven by a variety of supply and demand factors which make up a separate market for rentable space. As investors consider an acquisition, they must project future movements of this market as it relates to the specific asset.

If the space market is expected to yield future increases in rental rates, investors will pay a higher price for the current income stream, pushing the cap rate down. If the space market projects a weak outlook, investors will want to pay less, and cap rates will rise.

Being a simplified rate of return measure, cap rates are subject to the same risk/return trade-off as other measures. In short, cap rates move in tandem with risk, real or perceived. While risk aversion varies from person to person, generally, investors are willing to pay more for less risky assets. As such, assets with less risk will carry lower cap rates than assets with higher risk.

Reversionary edit

Property values based on capitalization rates are calculated on an "in-place" or "passing rent" basis, i.e. given the rental income generated from current tenancy agreements. In addition, a valuer also provides an Estimated Rental Value (ERV). The ERV states the valuer's opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation.

The difference between the in-place rent and the ERV is the reversionary value of the property. For example, with passing rent of $160,000, and an ERV of $200,000, the property is $40,000 reversionary. Holding the valuers cap rate constant at 8%, we could consider the property as having a current value of $2,000,000 based on passing rent, or $2,500,000 based on ERV.

Finally, if the passing rent payable on a property is equivalent to its ERV, it is said to be "Rack Rented".

Change in asset value edit

The cap rate only recognizes the cash flow a real estate investment produces and not the change in value of the property.

To get the unlevered rate of return on an investment, the real estate investor must add (or subtract) the percentage increase or decrease from the cap rate. For example, a property with a cap rate of 8%, which is projected to rise in value by 2%, delivers a 10% overall rate of return. The actual realised rate of return will depend on the amount of borrowed funds, or leverage, used to purchase the asset.

The most common metric used to quantify the percentage of leverage used to finance a real estate investment is the loan to value ratio (LTV), which compares the total loan amount to the appraised property value. In the commercial real estate (CRE) market, the typically maximum LTV ratio around 75%[11]

Historical trends edit

According to a national survey conducted by Commercial Real Estate Services (CBRE) in early 2021, typical cap rates in the US varied across geographical regions and urban market, but generally ranged between 4.5% and 6.5% for urban office properties, between 6.5% and 8.0% for suburban office properties, and between 3.5 and 5.0% for multifamily housing properties. The cap rates for industrial properties were normally somewhat greater, from the 2.5% to 6.0% range. According to the same survey, cap rates for retail properties in early 2021 typically ranged from 5.0 to 7.0%.

The National Council of Real Estate Investment Fiduciaries (NCREIF) in a Sept 30, 2007 report reported that for the prior year, for all properties income return was 5.7% and the appreciation return was 11.1%.

A Wall Street Journal report using data from Real Capital Analytics and Federal Reserve[12] showed that from the beginning of 2001 to end of 2007, the cap rate for offices dropped from about 10% to 5.5%, and for apartments from about 8.5% to 6%. At the peak of the real estate bubble in 2006 and 2007, some deals were done at even lower rates: for instance, New York City's Stuyvesant Town and Peter Cooper Village apartment buildings sold at a cap rate of 3.1% based on highly optimistic assumptions.[13] Most deals at these low rates used a great deal of leverage in an attempt to lift equity returns, generating negative cashflows and refinancing difficulties.[14]

As U.S. real estate sale prices have declined faster than rents due to the economic crisis, cap rates have returned to higher levels: as of December 2009, to 8.8% for office buildings in central business districts and 7.36% for apartment buildings.[15]

See also edit

References edit

  1. ^ "Cap Rates, Explained | JPMorgan Chase". www.jpmorgan.com. Retrieved 2024-02-09.
  2. ^ "Assessor's Cap Rate Policy | Cook County Assessor's Office". www.cookcountyassessor.com. Retrieved 2024-02-09.
  3. ^ "Cap Rate Primer | Formula + Calculator". Wall Street Prep. Retrieved 2024-02-09.
  4. ^ Kattan, Danny. "Council Post: When A Cap Rate Is Not A Cap Rate". Forbes. Retrieved 2024-02-09.
  5. ^ "Real Estate Finance and Investments: Risks and Opportunities, Peter Linneman, PhD and Bruce Kirsch, REFAI". Real Estate Finance and Investments: Risks and Opportunities, Peter Linneman, PhD and Bruce Kirsch, REFAI. Retrieved 2024-02-09.
  6. ^ "Allocation of Costs to Land When Purchasing Real Estate". Marcum LLP. 2016-06-15. Retrieved 2024-02-09.
  7. ^ "Overall Capitalization Rate (OAR)". ClearCapital.com, Inc. Retrieved 2024-02-09.
  8. ^ "Valuations | Property Valuation Generator". valuations.crecos.gr. Retrieved 2024-02-09.
  9. ^ "Capitalization Rate Definition | Commercial Loan Direct". www.commercialloandirect.com. Retrieved 2024-02-09.
  10. ^ Geltner, David (2014). Commercial Real Estate Analysis and Investments, Third Edition. Mason, OH: OnCourse Learning. p. 18. ISBN 978-1-133-10882-5.
  11. ^ "Basel Framework". www.bis.org. Retrieved 2024-02-09.
  12. ^ "Capitalization Rates Were Mixed in May". Wall Street Journal. 26 June 2008. Retrieved 2023-03-10.
  13. ^ "Northeast Real Estate Business". www.northeastrebusiness.com.
  14. ^ Writer, SAMANTHA GROSS, Associated Press. "Owners: $5.4B NY housing complexes go to creditors".{{cite web}}: CS1 maint: multiple names: authors list (link)
  15. ^ https://www.wsj.com/articles/SB20001424052748703906204575027304238657576[dead link]