Cap Rate (REIT)

There are many ways to invest in real estate. For example, investors can own residential units, rental land, or own shares of a REIT. If you are familiar with real estate financial analysis, then you will already be familiar with the importance of cap rate. So, how do they work together?

If you need a brief refresher, the cap rate, formally capitalization rate, is a metric that allows investors to understand the true earning potential of an individual real estate investment. It is essentially the potential annual returns of a property relative to its value.

A REIT, short for real estate investment trust, is a corporation that takes pooled investors' cash and debt, then invests 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 one of 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, in a little more detail, what it is. Then we can try to understand how to calculate it for a REIT.

What is the cap rate?

It helps investors understand if the asset itself a good investment is. Then, properties with similar risk factors can be compared directly against each other without the specifics of an individual's finances clouding the quality of the investment.

How is the cap rate calculated?

Cap rate = net operating income / property value

Net operating income is the income generated by the property after operating expenses. In this respect, it is relatively similar to the operating income of a corporation.

It includes total rent and other sources of income (parking, storage, etc.). Once this has been calculated, the analyst can deduct operating expenses such as property tax, utilities, insurance, etc. NOI does not include the mortgage/loan payments for interest or principal repayment.

On the other end, property value can be found in a few ways. Property values can be estimated by comparing the NOI and cap rates of similar properties. In the case of purchasing, property value is just the selling price.

Property value may also be reassessed by the government to update the property tax rate, at which point the investor may wish to recalculate their cap rate. This is the best practice as the investor can account for both new rent rates and costs of property tax.

How does the capitalization rate work?

The capitalization rate can be used by both buyers and sellers. Buyers are concerned with what they should earn from the property, and what those earnings are worth to them. Sellers should make sure they only accept fair bids for their property, especially if it is income-generating.

The capitalization rate is useful for all real estate investors. As we mentioned, the capitalization rate is one of the most important metrics in real estate financial analysis. It can relay the suggested price of the property and create a ratio that focuses on the property's intrinsic value.

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 by helping quantitatively dissect the market's expected returns on real estate and 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 a price difference, and the buildings themselves are also unlikely to be identical. The rental income of each property may differ as well.

Rather than arbitrarily picking the cheapest property or the one that can generate the largest gross rental income, the capitalization rate helps an investor pick whichever option matches their desired rate of return.

Using this ideal, investors can also reverse the capitalization rate formula and figure out what they should pay for the property.

Property value = NOI / average cap rate for similar properties

So not only can buyers determine the income potential relative to investment, but they can estimate the fair price to pay for the rental property as well.

With inflation on the rise (as of writing this article), repairs including the costs of goods and services are also on the rise. Investors should continually pay attention to their costs and re-evaluate their capitalization rate to ensure they are getting an adequate return on investment.

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 the property is being sold, and then looking for similar property capitalization rates. Therefore, it is possible to find at what price range the seller should expect to close a deal at.

Checking other current listings, paired with knowledge of local rental rates, it is possible to estimate what the intrinsic value of the property is. 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 the management of a REIT should understand the capitalization rate and how it can estimate how much money their properties bring in for the business.

This insight also affords the income trusts' management the ability to target properties that are in line with the goals of the fund (for example high yield for high-risk properties, or high-class properties with fair yield rates).

Why use cap rates when analyzing REITs?

REITs typically give out most of their cash flow to investors through distributions. It is like owning the property itself, but only a very small proportion per share and investors do not have to worry about property management as it is baked into the expenses on the REITs' income statement.

Because of this similarity between the shares of the asset, and actual real estate, it is clear that capitalization rates would be great tools for analyzing REITs.

Since REITs give out most of their cash flow in distributions, there is often no complex layer of understanding of how free cash flow is being used to grow the business. REITs finance further property acquisitions through debt and issuance of new shares.

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

Let us explain what we mean by the above.

REITs' primary asset is property, but the property itself likely doesn't lose its entire value over the next 25 years, or whatever rate of depreciation is applied to the property. Yet, the asset price will continue to be the cost of purchasing the asset or less depending on depreciation.

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 it is part of accounting practices to depreciate assets over time to 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, free cash flow is also affected by this sale, and investors receive most of the free cash flows, instead of the firm retaining them. 

Lastly, ROIC is not that reliable since there is little in the manner of net working capital since the main selling point of a REIT is the property itself.

So, these ratios are not great, and capitalization rates are an important metric for real estate financial analysis. It seems that a business that deals primarily in real estate would be appropriately analyzed using cap rate for part of the analysis.

How to measure the cap rate of a REIT?

This is quite the task since REITs do not have to publicly disclose their capitalization rates to anyone. But we know that capitalization rates are important in real estate, so there must be some way to measure the cap rate for a property, right?

So, if the following is how to measure the capitalization rate of an individual property:

Cap rate = NOI / current market value of the property

Since NOI is the cash flow after operating expenses, we can find this on the income statement. The trouble is in establishing this in relation to the market values of the properties they own.

In theory, there is still a way to determine this on a 10K. By finding additional operating income between one year, and the year before it you can isolate additions to operating income. The 10K should disclose net operating income on it.

The next step would be determining additions of properties to the balance sheet, which would be notably the additions to the property line of the balance sheet. This may also be found in the footnotes, but if not check the PPE section.

Next:

(This year's operating income - last year's operating income) / (This year's total asset value of properties - last year's asset value of properties)

By taking the difference between additional property, and additional net operating income, an investor can attempt to determine what rate additional properties generate income. It is like determining how much extra income is generated by additional property purchases.

This can be a little speculative in nature, and investors should be mindful that each year should be compared individually. Also, years with negative growth on the balance sheet are not particularly useful since it is nearly impossible to determine the capitalization rate.

Lastly, years with one-off events may also not be quite as reliable. For example, if there was a large unwinding of property one year, that will generate a large influx of income and cash flow as well as a significant decrease in property on the balance sheet.

An alternative metric is to consider trends for funds from operations. Some may not consider this as important as capitalization rate, since it includes interest and taxes which are subject to the company's particular financial situation and not the properties in which they invest.

However, funds from operations are explicitly stated, at the very least in the footnotes of financial filings. FFO is still reliable as it adds back depreciation and takes out sales of property which allows investors to focus more on the actual cash generated from operations. 

Depreciation is a non-cash item, and selling property is not a sustainable practice long-term. Removing both figures generates a more reliable figure for potential investors.

Professional analysts will use AFFO or adjusted funds from operations.

AFFO = FFO + rent increases - capital expenditures - routine maintenance amounts

This metric is also considered quite reliable as it additionally considers maintenance and CAPEX against rent rate increases, on top of the considerations for FFO.

Back to the focus on capitalization rates and REITs, they are a good way to see how management deploys its funds, and how efficiently they are buying new properties. 

If they are making more significant investments in years with high cap rates, this is typically a good sign. On the flip side, if their capitalization rates are very low, this might make it hard for the REIT to maintain large distributions in the long term.

Researched and authored by Brandon Fausto | LinkedIn

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