The capitalization rate, also called the cap rate, is a fundamental technique used for calculating the value in commercial real estate.
Cap Rate Definition:
Capitalization rates, or just cap rate, is the ratio of Net Operating Income (NOI) to asset value. If a property sold for $100,000 and generates $8,000 of income after expenses (but before finance costs), then the cap rate would be $8,000 / $100,000 which is 8%.
What is a “Cap Rate?”
The capitalization rate is one method used to determine the value of income producing property. It is related to but fundamentally different than the gross rent multiplier.
The gross rent multiplier uses only the income to give a rough estimate of property and is generally used as a quick screening tool. The cap rate uses the entire picture – both income and expenses to determine property value.
It’s also important to note that the Gross Rent Multiplier and the Cap Rate are inversely related. The GRM is a price to earnings ratio while cap rate is the return on investment.
Though using cap rates to value property or your return on investment can be very accurate most of the time, it is still not applicable in some circumstances.
How to Calculate Cap Rates
Let’s take the most common application of cap rates. If you are considering purchasing an apartment building that is listed for $2,000,000 and has an NOI of $130,000, then it would be said to have a cap rate of 6.5% (or 6.5 cap).
Cap rate examples
Cap rates can also be used to back into an offer price. Let’s use the example above.
If your apartment building has an NOI of $130,000 but you know the market in your area has a 7% cap rate, you can calculate an offer price.
Here it would be $130,000 / .07 = $1,857,142.
So, you could say the market value of this property would be $1.86 million based on a 7% cap rate.
If cap rates are 6% in the market, you know the market value is closer to $2.17 million. You would have some room to bid up, or create excess equity.
Market Cap Rates Can be Tough To Estimate
One problem with cap rates is there are a lot of different rates in any one market.
Cap rates could alternatively be thought of as a risk premium. Certain buildings will be riskier than others, so they will demand a higher return to compensate the investors.
So you need a lot of data to try to break down the cap rate in each “class” of property. Once you have categorized all the other properties in the market, you can place this property into one of those classes.
You can’t expect a Class A property to have the same cap rate as a Class C property. The C property will clearly require a higher rate of return to compensate the investors for its perceived risk.
Another Way to Look at Capitalization Rates
Cap rate, along with any rate of return, can be looked at as the risk premium required to accept a given level of risk plus the risk-free rate of return.
So, if the current treasury yield is 1.6% and the cap rate for your potential property is 6%, then the risk premium is 4.4%.
Stated another way, you are being compensated an additional 4.4% to move your money from the safest investment (treasuries) and accept all the inherent risks of the investment property.
These risks could include:
- Age and condition of the property
- The type of tenants
- Market fundamentals (city/state is growing, gaining jobs, etc)
- Broader economic fundamentals (recession or growth)
When to Use Cap Rates
Cap rates are great for quickly comparing multiple properties in a given geographic area.
If one property is a 6% cap and the other is 8%, you know that one is riskier. Alternately, one may be overpriced or under-priced.
Cap rates are also good for determining market trends.
If cap rates are increasing or decreasing in a particular market, you may be able to understand the general trend. By looking at trends you may be able to decide if a certain market is over-valued or being sold at a discount relative to a long-run trend.
Cap rates can also determine when a property is being mismanaged.
If you find a property in a great location but has a high cap rate, it’s possible that the management has deferred maintenance or had low criteria for tenants. Ultimately these problems will decrease the quality and increase the risk.
It could create an opportunity for a “value add” by completing deferred maintenance and “stabilizing” the tenant base. Not only will profits increase, but you may be able to lower it’s risk premium and create value.
Cap Rate Risk Premium Example
Let’s say you identified a mismanaged C class property that would be a B- if it were managed well.
It has an NOI of $100,000 and is selling at a 7% cap rate for $1.43 million.
Now let’s say you put $100,000 of work into the property and raise the NOI to $110,000. At a 7% cap rate, the new value is $1.57 million. Not bad, you created about $40,000 in equity.
But, what if by doing the upgrades and making the tenant base higher quality, you have reduced the risk of the property from a C to a B-. In this imaginary market, let’s say a B- is going for a 6.7% cap rate.
You are now rewarded with a property that is worth $110,000 / .067 = $1.64 million.
You’ve created $40,000 in value through renovations then an additional $70,000 by reducing the risk for a grand total of $110,000 in equity.
When You Shouldn’t Use Capitalization Rates
If the property has a complex income stream that is irregular or will have large variations in cash flow it can be hard to estimate your rate of return. In these situations, it is better to use a discounted cash flow analysis.
For example, you may purchase a property and plan multiple phases of major renovations over a 3 year period. The renovations may cause high vacancy rates sporadically and create different rental rates at different points of time.
This sort of analysis is beyond the scope of cap rates and you would need something more advanced.
Cap rates also aren’t good at calculating the value of certain types of buildings with unique purposes. An example would be a large or historical structure such as a church or cathedral. These sorts of buildings would be valued using a cost approach.
Cap rates are also terrible at valuing properties that may be owner-occupied. These tend to be 1-4 unit residential properties but can include small mixed-use buildings.
4 units is not a strict cut-off, and buildings with slightly more may use a hybrid approach.
I general, a small residential property would be valued with the sales comparison approach, which can be estimated with a comparative market analysis.
Rental and Commercial Property Valuation is Complicated
There is no exact answer to evaluating the value of any property. Everyone has a different risk tolerance and ROI goals. What may be a good deal to one person may be a terrible deal to another person.
These methods should be used to help you analyze if the deal is good for you. It can’t be used to judge if the deal is good for someone else.
You need to be armed with knowledge about every aspect of property valuation and return calculations in order to get what you want out of your investments.
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