How are cap rates used?

TheTankF's picture
Rank: Baboon | 139

I know it's NOI/Value, but how can it be given? How can people say, "cap rates are really high right now" or "we're underwriting it at a 6 cap, building to a 7 cap, selling at an 5 cap."

How is it anything more than a ratio?

Comments (39)

Nov 7, 2017

it's just a way to determine what things are trading at. Similar to P/E ratio in equities. In addition to what you mention, you could use it to determine what things are trading at with certain product types or in certain geographical regions. For instance, high street retail are trading at 2.5% in New York but office buildings in downtown San Francisco are trading at 5.5%.

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Nov 7, 2017
TheTankF:

I know it's NOI/Value, but how can it be given? How can people say, "cap rates are really high right now" or "we're underwriting it at a 6 cap, building to a 7 cap, selling at an 5 cap."

How is it anything more than a ratio?

It's not anything more than a ratio, but ratios are pretty meaningful in real estate.

If a property down the street has an annual NOI of $2,000,000 (keeping it simple - some people use trending NOI, some use projected next year NOI, etc.) and someone just paid $40,000,000 for it, that means it sold at a 5 cap, right? Well that ratio (the 5 cap) is pretty damn important to you, as a developer, because you are able to more accurately underwrite your deal in that same neighborhood.

If you have no idea what someone would pay for your cash flow, it's really hard to know if a deal makes sense. How will you know what you can refinance at after the construction loan at say 75% LTV if you don't know what the V is. How will you know what you can sell your property for if you can't anticipate what an investor would pay for it?

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Nov 7, 2017

Cap Rates can also be viewed as rough estimate for the annual yield on your investment. The firm I worked for this summer partnered with a large LifeCo on an office project. The partnership underwrote and built to an 8 cap because 8% was what they required annually to make that investment worthwhile.

Real Estate has been a great substitute for bonds with interest rates being so low.

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Nov 8, 2017
Mark Queban:

Cap Rates can also be viewed as rough estimate for the annual yield on your investment. The firm I worked for this summer partnered with a large LifeCo on an office project. The partnership underwrote and built to an 8 cap because 8% was what they required annually to make that investment worthwhile.

Real Estate has been a great substitute for bonds with interest rates being so low.

Otherwise known as a going-in cap rate, yield on cost, return-on-cost, etc

^^just in case someone performing a random internet search doesn't understand going in vs disposition :)

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Nov 7, 2017

A ratio of risk as well.

If major markets are trading multi-tenant retail deals at a 5.75 cap, and you're in another market thinking you're laughing your way to the bank with an 8 cap, well, hold on for a bumpy ride.

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Nov 10, 2017

It's simply an easy (but dumb) measure to compare two options within a single market. RE deals are so complex that true apples-to-apples comparisons are challenging. Cap rates allow you to compare deals using variables that are intrinsic to the property (NOI) and the market (value based on comps).

If you wrote two proforma for two different projects, you would probably have a very different comparison versus just using cap rates.

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Nov 10, 2017

Not sure exactly why one would want a 'lower' cap rate...usually the higher the better (maybe it's different on the debt side? Hopefully someone else can chime in here).

As for what a cap rate is, as an equity investor you'd want a higher cap rate, especially relative to the current market/submarket, cause it basically represents your yield. For example, if you buy a building for $100m and NOI is $10m, then you bought it for a 10 cap (10% cap rate = $10m/$100m). Thus, as an equity investor, why would you want a building that only yields $3m in NOI in year 1 but you still pay $100m for? (a 3% cap rate - been seeing even lower cap rates in the market I currently work on, i.e. the market is HOT and there is too much money chasing after too few deals).

Hope that makes sense and I'm curious as to what others say in terms of wanting a "lower cap rate."

Nov 10, 2017

Lower cap rate means the lender can put out more $$. Say the lender can't go above 80% loan to value. The lower the cap rate, the higher the value, the more money a lender can put out.

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Nov 10, 2017

All,

Thanks for the input so far. To clarify a little more, this would be from our lenders prospective. Yes, the maximum we can go is 80% LTV. I believe I was bushing on that before. The lower the cap...the higher the value (larger the possible loan). Correct? So if we compare Caps in Manhattan vs Brooklyn...you would say in general Manhattan has lower cap #'s just because market value of the properties are so high compared to Brooklyn? Just in general.

Nov 10, 2017

I don't agree with the above; a lower cap rate doesn't necessarily mean better or worse. It all depends on your objectives as an investor, whether you are a pension fund seeking return stability or a more risk tolerant owner looking for higher returns in a shaky market. Cap rate is effectively an expression of how much a buyer is willing to pay for the NOI cash flows. The reciprocal of the cap rate basically dictates how many times someone will pay for the NOI. Typically, a lower cap rate is a reflection of much tighter market where there is a lot of capital chasing fewer deals; consequently, potential buyers are willing to pay more for the cash flows to own a building.

Nov 10, 2017

It all comes down to the very simplistic formula that all of us use every single day: Value = NOI / Cap Rate.

From an owners / sellers perspective, you will want to get the lowest cap rate possible when seeking financing or disposing of an asset. As mentioned before, the lower the cap rate, the more value someone is (a seller, buyer, lender, whoever) attributing to the asset.

When you are a lender, you really want to put cushion into your deal to ensure you have a safe place in the capital stack should something go wrong - a market crash, stagnant leasing market, or some huge capex is discovered later on that was not found during underwriting.

Underwriting is really both an art and a science from anyone's perspective. For a lender, they will need to walk a fine line of being conservative (for cushion as mentioned above) and aggressive to provide the best debt terms for the owner. If they are too conservative (ig. put a HIGHER caprate on the asset) they will never get a deal. If they are too aggressive, they can really fuck themselves when something goes wrong.

Nov 10, 2017

Great, thanks. Now, what is generally viewed as an approproate Cap in different markets. I don't need a rundown of the entire US. Let's say a few examples...Manhattan vs Brookly, Miami, and a smaller city like Chalotte.

Nov 10, 2017

CBRE provides national cap rate surveys for all property types nationwide. This report is 1 years old, perhaps another member has access to something more recent.

http://www.cbrecapitalmarkets.com/EN/KnowledgeCent...

Nov 10, 2017

@"GentlemanAndScholar" - Here is a good example of midtown product in a different borough. it is NNN leased to Citi so you have 100% rollover in 2020, and it traded for $350 psf in 2012 - that's a discount of over 50% i'd say. http://nypost.com/2012/07/18/lic-Citi-tower-sells-...

Nov 10, 2017

Thanks, Chris. This would support the logic of inferior locations warrant lower value. But to really drive the point home to help others understand cap rates, we would need to know how much Citibank is paying in base revenue. To muddy the waters, here are a few examples of when an asset will trade above (or below, see bullet #3) "typical" market cap rates:

-seller wants to exit for various issues (issue with JV, strapped for cash, needs to harvest to return capital to investors, etc)
-tenants signed a lease at the peak of the market and are paying above market rents
-tenants signed a lease at the trough of the market and are paying below market rents
-buildings that have near term roll
-non-credit tenants
-inferior locations (point I was trying to originally make)
-lack of parking
-etc.

There's a finite number of monopoly trophy assets out there, and in a normal transaction with normal sellers, downtown CBD trophy assets can trade in 2-3% cap rate range.

Nov 10, 2017

lower cap rate basically means lower yield but less risk

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Nov 10, 2017

Risk profile. Based on your example I'd expect the higher cap for the Riskier value add. I would expect to stabilize to a higher yield than the "easier" class A investment. That's how you should think of it. Lower risk = lower return. Class A would trade at smaller cap (i.e. More expensive) than stabilized value add class B because it's less risk. All things being equal that is. I wouldn't pay a premium for a riskier project

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Nov 10, 2017

Thanks so much for your help!

If both buildings have the same NOI, I would think that that an investor would pay a lot more for the building where they also have many different ways that they can increase cash flow.

Under any circumstance would the Value-add building have a lower cap and be less risky than the Class A building because both buildings have the same cash flow but the value-add building has room to be more profitable?

Best Response
Nov 10, 2017

Basically the perceived risk.

A 15 year NNN McDonalds with a corporate guaranty will be a much lower risk than a 50 year old duplex in a crap part of town.

This is because the McDonalds is basically guaranteed income for the next 15 years with no landlord responsibilities outside of cashing the checks. The 50 year old duplex will probably have lots of maintenance, the tenants will be garbage and probably wont pay rent on time, and you won't be guaranteed that income year in and year out.

Using your example, the class A would have a lower cap because it is a lot less risky than a value add.

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Nov 10, 2017

I don't know why you got MS(Monkey Poop), this seemed like an innocent enough question.

What you have to look at is not only the yield but in real estate the location. Just like a bond you would pay a higher premium or price for an asset that has a less of a chance of defaulting. Because real estate is very similar to a fixed asset investment you should look at it as yield vs price. If an asset has a lower price and has the same nominal yield in your example you should infer that either it is not in the same location, has riskier tenants and there for less secure cash flow than the lower cap rate product. Just like a bond, again, investors want to be compensated for a risk premium, hence a higher cap rate for two equally income producing properties.

Nov 10, 2017

I really appreciate everyones help.

If both buildings have the same NOI, I would think that that an investor would pay a lot more for the building where they also have many different ways that they can increase cash flow.

Under any circumstance would the Value-add building have a lower cap and be less risky than the Class A building because both buildings have the same cash flow but the value-add building has room to be more profitable?

Nov 10, 2017

I mean you're not "wrong", but people pay for safety. Like the safety dance song.

Nov 10, 2017

Think of it this way: Why would you pay more for something that is riskier just because it has upside? Sure you have an opportunity to increase NOI but would you pay a premium for that risk? No way.

Nov 10, 2017

Also remember that a value add is going to take additional money, and possibly time to lease up.

If your acquisitions price is $1mm on a value add, you better be prepared to put additional money into improvements. Your building will also probably be vacant and you will not be making any money while you're doing those improvements.

Nov 10, 2017

This can also relate to stabilized noi vs actual noi on a value add property. If I think my noi is going to increase after I put tenants in all yhe vacant space a building has, I may pay an unrealistic cap rate on the income in place becuase it doesn't reflect what I think the actual income will be. My cap rate on stabilized income should still be higher though to reflect the risk on leasing up the property.

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Nov 10, 2017

Another way of looking at this is that the Cap Rate = Discount Rate (Investor Required Rate of Return) - NOI Growth. Now assuming identical growth on both leases, an investor would be willing to accept a lower rate of return on a high quality (Class A) tenant lease because there is less chance that the tenant will vacate than an another lower quality tenant.

Regarding your questions about the possibility of increasing cashflow, this too comes with the added risk of not being able to realize this increase in CF - say you allocate money to a refurbishment of a building but cannot relaise the increased rentals you were expecting to achieve - all in all its risk/reward payoff as others have mentioned

Nov 10, 2017

not a bad explanation, but just to be clear: cap rate = discount rate MINUS NOI growth

Nov 10, 2017
RE-Student:

A building with a $50,000 NOI at a 4% cap is valued at $1.25 M while a building with a $50,000 NOI at a 6% cap is valued at $833,000. Wouldn't the building with the higher returns be valued at a higher price?

Esoteric real estate crap aside, you're conflating the valuation and the cap rate. The "returns" are higher because you're paying less for the same cash flow. In this scenario, the price/value is your denominator, from which you can calculate the yield, which is your cap rate.

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Nov 10, 2017

CBRE Cap rate survey, they do one twice a year.

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Nov 10, 2017

^

Nov 10, 2017
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Nov 8, 2017