What's the difference between them? Do you use cap rates or IRR to value RE assets? Wouldn't it make sense to go for a a project with a cap rate of say 15%? How do you fundamentally calculate cap rates? and I dont mean income/purchase price....is it essentially IRR-expected growth? Just looking for more details around this IRR vs cap rate debate.
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Fundamentally, IRR is the cap rate that makes the NPV of an asset equal to 0. Anything greater than 0 would represent potential profit (make the investment), anything less would represent loss (dont make the investment). Perhaps the more experienced monkeys can chime in on how to calculate cap rates but most of it has to do with the surrounding market environment and comps, no?
Good posts thus far. OP, you should be able to figure it out given the above posts and info on Wiki.
http://en.wikipedia.org/wiki/Capitalization_rate
It would make sense to go for a project with a cap rate of 15% if you were enjoy risk. Similar to the bond market, the higher expected return, the more risky the project is going to be. Most cap rates are anywhere from 6-12% depending on location. The way to determine cap rate is NOI/V, however to double check this, you could look at sales comps and compare cap rates, or do a band of investment if you can confirm typical mortgage terms for the subject. If you think that a project is going to boom due to market factors, you might adjust your cap rate downwards if you are willing to pay a higher price to obtain.
For the most part the cap rates used in real estate valuation are market driven and tweaked based on your own assumptions (or your boss's). If I know the risk parameters of the project and am familiar with local comps I would calculate the target buildings NOI, slap a cap rate on it (NOI/cap rate), and come up with a value. Also remember that cap rate = discount rate - growth
http://www.propertymetrics.com/blog/2013/03/01/difference-between-cap-r…
This guy knows what he's talking about, the other posters are... Spotty at best.
Cap rate is, by definition, NOI/value. But cap rate is a market driven metric, there really no way to calculate an absolutely "correct" cap rate, buildings are worth what people are willing to pay. A cap rate essentially just pretends that the NOI is a perpetuity and discounts that perpetuity to today.
IRR on a real estate trade is the same as IRR anywhere else. It's not a valuation metric, it's IRR. IRR is a function of entry cap and exit cap, among other things.
interesting point. Why is cap rate the difference between discount rate and growth? How does the math work? Why do you substract growth? If that is the case, then from the point of an investor a cap rate doesnt really tell you that much then because it doesnt answer the main question (i.e. what is my IRR on investment if I choose to buy an RE asset). That is because the IRR is IMPLIED in the cap rate but since the cap rate also accounts for growth and having no idea of what that is then I cant tell what my return will be correct?
For what it's worth, I went through some modeling with a Director at a large CRE company and they used the term "cap rate," as synonymous with their internal required rate of return for acquisitions for their REIT group.
They used the cap rate required for their fund and NOI of the current year to determine pricing for potential acquisitions. As Junk pointed out above me, they used it for NOI/Cap Rate to determine a acquisition price.
Where as with a cash flow model, they were determining unlevered v. levered IRR through the discounting of all cash flows to a NPV of 0.
Cap Rate is simply what an individual is willing to pay for a property. Cap rates are based on risk and markets. Example, an office building is NYC will have a lower cap rate than one in Detroit since the risk in NYC is much less. IRR is simply a metric that shows return on cash. IRR is calculcated using leverage and cost of debt.
A cap rate isn't what someone is willing to pay for a property, it's the discount rate they use to discount the NOI (if you're not familiar with CRE metrics, NOI is similar to EBITDA) they assume the building will throw off in perpetuity.
The concepts are related but the distinction is important. It's a metric that values the Property in terms of cash flows, not necessarily in terms of inherent real estate value (although the two very often overlap.)
For example, to go along with your NYC vs. Detroit office example. While it's true that, in general, the NYC cap rate will be lower, if we assume that the Detroit office is 100% occupied by a rock solid company on a 100 year money good lease, while the NY building had a shitty capital starved lease-up structure, it's really not impossible to imagine a lower cap on the Detroit building.
The cap is valuing the cash flows, not the building per se. You know?
^^^ Yes, the two overlap. I should have went into more detail. Also in the NYC example, I was generalizing, but of course if the occupancy sucks and the building is in need of repair, then the cap rate will be higher.
Cap rate is basically Discount Rate-Growth because the cap rate formula mimics the perpetuity formula. Value=NOI/Cap, Value=Dividend/(Discount-Growth). From an investor, the cap rate is a quick way of telling you if you are overpaying or underpaying for a project. IRR can only be calculated in-house because other investors won't use the same holding period as you. If it's still too tricky to get a grasp on cap rates, take the inverse of the cap rate. For example a 6% cap rate inverse would be a NOI multiplier of 16.67 (1/.06). This tells you that it would take 16.67 years to get back you initial purchase costs. It's appropriate to use the perpetuity (cap) formula to determine market value because real estate is a perpetuity, meaning it will yield an income stream forever.
Solid explanation. Would SB if I had any.
Going with Ausy21's comment. A cap rate is simply the difference between your required rate of return and your expected rental growth during the hold period of the asset. This way of looking at cap rates helps assess if properties are overvalued or not. If you're underwriting a multifamily deal where a building is for sale at a 4% cap and hour WACC is 12%. The question you have to ask yourself is : "is it realistic to have an 8% annual rent growth over my hold period". In this case I would not consider the deal. Happy to hear the thoughts of experts.
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