Cap Rate (REIT)
A metric that allows investors to understand the earning potential of income-producing real estate assets, including those held within a REIT portfolio
What is Cap Rate (REIT)?
Cap Rate (REIT), or Capitalization Rate for Real Estate Investment Trusts, is a metric that allows investors to understand the earning potential of income-producing real estate assets, including those held within a REIT portfolio.
It is essentially the potential annual returns of a property relative to its value.
There are many ways to invest in real estate. Investors can own residential units, rental land, or shares of a REIT. If you are familiar with real estate financial analysis, you will already know the importance of cap rates.
So, how do they work together?
A REIT is a corporation that takes pooled investors' cash and debt and invests it in property. These corporations often specialize in one or a few specific real estate types, allowing investors to choose which class they prefer to invest in.
Notably, the cap rate is among the most important metrics for many individual and institutional real estate investors. So, understanding how to apply it to a REIT is very important. However, it is not a straightforward task.
Before we get to that, let's discuss it in more detail. Then, we can try to understand how to calculate it for a REIT.
Key Takeaways
- Cap Rate (REIT) measures the earning potential of income-producing real estate assets within a REIT portfolio. It's the annual returns of a property relative to its value, aiding investors in assessing investment potential and setting asking prices.
- Calculated as Net Operating Income (NOI) divided by current market value, the Cap Rate helps investors compare properties and make informed decisions. It's crucial for aligning investments with risk tolerance and objectives.
- Investors use Cap Rates to evaluate income potential and estimate fair property prices. Cap rates assist them in selecting properties that align with their goals and risk preferences.
- For sellers, Cap Rate estimation guides pricing decisions based on market comparables and rental rates, facilitating transactions and informed negotiations.
- While Cap Rates are valuable for property-focused analysis, investors should consider other metrics like free cash flow, ROE, and ROIC to evaluate REIT performance and investment potential comprehensively.
How to Calculate Cap Rate
Cap Rate (REIT) helps investors understand whether the asset itself is a good investment. Then, properties with similar risk factors can be compared directly without the specifics of an individual's finances clouding the quality of the investment.
To calculate, we'll use:
Cap Rate = Net Operating Income (NOI)/ Current Market Value (Property's Purchase Price or Appraisal Value)
Net operating income is the income generated by the property after operating expenses. In this respect, it is relatively similar to a corporation's operating income.
Net operating income includes rental income and other sources, such as parking and storage fees, minus operating expenses like property tax, utilities, and insurance, but does not include mortgage or loan payments.
Note
NOI does not include the mortgage/loan payments for interest or principal repayment.
On the other hand, the current market value represents the amount that a property can be sold for in the current marketplace. The value is obtained by comparing the recent sales prices of similar properties in the area.
How Investors Use the Cap Rate
The capitalization rate is primarily used by buyers to evaluate a property's investment potential and by sellers to set an appropriate asking price based on market conditions.
The capitalization rate is useful for all real estate investors. As we mentioned, it is one of the most important real estate financial analysis metrics.
It can inform property valuation by establishing a ratio between a property's net operating income and market value, aiding investors in assessing its investment potential relative to other properties.
It can help align investors with the right properties for their goals. For example, a low-risk investor might take on a lower capitalization rate by paying more for a property to compensate for building conditions and property demand to help ensure there is a tenant on their property.
It is also useful for market research, helping to quantitatively dissect the market's expected returns on real estate and explain why certain properties are priced in specific ranges.
Buyer's perspective
You, the investor, might be looking at several different properties in a given area that are in your price range. Each property may have different prices and unique characteristics, impacting factors such as rental income and expenses.
While the capitalization rate aids investors in assessing the income potential relative to investment, it should be considered alongside other factors when making investment decisions rather than solely determining the investment choice.
While investors can reverse the capitalization rate formula to estimate property value, it should be used cautiously alongside other valuation methods to ensure accuracy and reliability. To calculate, we'll use:
Property Value = NOI / Average Cap Rate for similar properties
So, buyers can determine the income potential relative to investment and estimate the fair price to pay for the rental property.
With inflation on the rise (as of writing this article), repairs, including the costs of goods and services, are also rising. Investors should continually pay attention to their costs and reevaluate their capitalization rate to ensure an adequate return on investment.
Note
If expenses are getting out of hand, it may be time to find ways of increasing NOI, including raising rental rates. Alternatively, if rental rates in the area are outpacing expense increases, some room may be created in the budget for property improvement.
Seller's perspective
As we discussed on the buyers' side, it is possible to estimate property value based on the area where the property is being sold and then look for similar property capitalization rates. Therefore, it is possible to determine the price range the seller should expect to close a deal.
Checking other current listings, paired with knowledge of local rental rates, makes it possible to estimate the property's intrinsic value. If unsure, investors can also ask local brokers and real estate agents to see if they have insights.
So, from either the buyer's or seller's perspective, it is clear that a REIT's management should understand the capitalization rate and how it can estimate how much money its properties bring in for the business.
This insight also affords the income trusts' management the ability to target properties that align with the fund's goals (for example, high yield for high-risk properties or high-class properties with fair yield rates).
Cap Rate (REIT) Examples
Let's consider a REIT that specializes in owning and operating office buildings. Suppose this REIT owns an office property with an annual net operating income (NOI) of $1,000,000. The property's market value is $15,000,000.
To calculate the cap rate:
Cap Rate = (NOI / Property Value) * 100
= ($1,000,000 / $15,000,000) * 100 ≈ 6.67%
So, the cap rate for this office building REIT is approximately 6.67%.
Now, let's consider a REIT that focuses on retail malls. Suppose this REIT owns a mall generating an annual NOI of $2,500,000. The market value of the mall is $40,000,000. To find the cap rate:
= ($2,500,000 / $40,000,000) * 100
≈ 6.25%
Therefore, the cap rate for this retail mall REIT is approximately 6.25%.
Why use cap rates when analyzing REITs?
REITs typically distribute most of their cash flow to investors. This is like owning the property, but only a small proportion per share. Investors do not have to worry about property management, as it is baked into the REITs' income statement expenses.
Because of this similarity between the shares of the asset and actual real estate, capitalization rates would be great tools for analyzing REITs.
While REITs distribute a significant portion of their cash flow to investors, it's essential to understand how free cash flow is utilized to evaluate the business's growth prospects and financial health.
This has a few implications:
- Free cash flow is not as useful since it is mostly given away in distributions
- ROE is not as useful since the properties may be fully depreciated before the property's useful life is up
- ROIC is also less useful since the business is primarily rental units
While property values may appreciate over time, depreciation accounting practices in real estate often spread out the cost of acquiring new properties over their useful lives, impacting the reported asset values on financial statements.
Note
In reality, real estate appreciates over time, most of the time. However, this appreciation is not recorded till the point of sale of a property. This means that properties are often over-depreciated despite their intrinsic value.
REITs do this because depreciating assets over time is a practice in accounting, and it helps spread out the costs of, for example, buying a new property.
So, the ROE becomes less useful because some years may be significantly affected by the sale of a property, which can be well above the adjusted cost base of the property.
To the same effect, this sale also affects free cash flow, and investors receive most of the free cash flows instead of the firm retaining them. Lastly, ROIC is not very reliable since there is little net working capital, and a REIT's main selling point is the property itself.
While capitalization rates are important for real estate financial analysis, they should be used alongside other financial ratios and metrics to evaluate REITs' performance and investment potential comprehensively.
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