The rate of return based on the net operating income that a property generates
The capitalization rate or cap rate is a profitability metric used in real estate. It is expressed as a percentage and is a function of the income that a property generates and its total market value.
The cap rate, in other words, is the rate of return on a property. It also gives an idea of how long it would take to recover the full investment. The capitalization rate can also be defined as a payback rate.
The cap rate is most commonly used to compare real estate investments. It is calculated by dividing the(NOI) that a property generates by the current market value.
The reason it's called the "capitalization" rate is that it can be used to derive the property value (the capital required to buy it) from its cash flows. This number typically does not consider debt - only equity - but debt can be added to make more accurate predictions.
The most common use for this ratio is with commercial real estate investments, but it can also be applied to any type of income-generating assets, such as stocks or bonds.
The terminal cap rate is a type of cap rate that divides the projected NOI for the last (also called exit) year by the asset's sale price.
Cap Rate: How To Calculate It?
The capitalisation rate is easy to calculate. It is the percentage return of the function between annual cash flows and asset market value. It is expressed as:
Capitalization Rate = Net Operating Income / Current Market Value
For example, a property with a $1 million current market value and $100,000 in annual net operating income would have a 10% cap rate. It means that the investor expects to make 10% on their investment each year as long as nothing changes with the property. Therefore, it will take ten years to recover the initial investment.
Using Cap Rate: A Four-Step Process
Following are the four steps to calculate and use the cap rate.
- Determine the annual net operating income of the property.
- Determine the purchase price of the property.
- Divide the annual net operating income by the purchase price to determine the cap rate for that particular property.
- Compare this number to other or similar properties to determine if it's a good investment.
The net operating income is the sum of all annual cash inflows that the real estate has produced minus the expenses associated with the property maintenance and other property expenses.
The NOI is the money that is left after paying the property bills. These expenses include but are not limited to:
- Property taxes, including the cost of land for commercial real estate
- Management fees
However, NOI excludes:
- Debt servicing, or the interest that is paid on loan to acquire the property
- Depreciation and amortization
- Capital expenditure (CapEx)
- Income taxes
- Tenant improvements (TI)
The net operating income is similar to another profitability metric - the earnings before interest, tax, depreciation, and amortization (EBITDA).
The current market value is what the real estate property is worth in the marketplace. The current market value can be above, below, or equal to the purchase price.
Benefits of the Cap Rate
The capitalization rate is a profitability metric used to compare investments. It can compare two or more different real estate opportunities and find which one is the most suitable for the investor.
It is a standard measurement in the real estate industry for evaluating potential investments. It is used to compare the profitability of different properties. All else being equal, a property with a higher cap rate is more desirable than one with a lower cap rate.
To determine whether a property has a high or low cap rate, the investor needs to set a capitalization rate benchmark from similar properties in that area. If it falls above that benchmark, it's considered high, and if it falls below that benchmark, it's considered low.
It can also be used to compare real estate investments as an asset class to another asset class, such as equity or debt instruments.
For example, suppose a real estate project returns 8% annually while the stock market and long-term bonds offer an annualized rate of return of 7% and 5%, respectively. In that case, the investor should favor the real estate investment, all else being equal.
Cap Rate Compression and Cap Rate Expansion
Property value, whether residential or commercial, depends on various factors such as geographical location, proximity to amenities, interest rates, and overall market conditions. These, in turn, affect the capitalization rate, which can either increase (expand) or decrease (compress).
We look at cap rate compression and expansion in the following sections.
Cap Rate Compression: What Is It?
Cap rate compression usually occurs when market prices rise, and investors are optimistic about the future. This is because the market price and the cap rate are inversely correlated, just like the value of a bond and its yield.
The higher the market value, the lower the cap rate. Generally, high-value properties in sought-after areas have lower capitalization rates.
It is important to note that the cap rate can also compress if the rent levels decrease while property rates remain the same. In such cases, it may be worth looking at the reasons for the stable property value despite decreasing rent. For example, if an investor has invested in the property to collect rent payments, decreasing rent can be a bad sign.
Cap Rate Expansion: What Is It?
When the market values and investors' sentiment drop, the cap rate increases. This is called cap rate expansion. The high cap rate compensates investors for their risk in purchasing properties. Typically, lower-value estates in more remote locations will command a higher rate. The high and low cap rates are associated with high and low risk, respectively.
Investors looking to buy properties to collect rental income usually favor those with high cap rates.
Capitalization Rate vs. Yield vs. ROI
The cap rate differs from the yield and the return on investment (ROI), two other profitability ratios.
The capitalization rate is based on the asset's current market price, while the yield is calculated based on the cost of the property. The current market value and the price paid for the asset can diverge over time. The two metrics will then produce different rates of return.
The ROI is different from the cap rate in that it takes into account leverage which is the loan taken out to finance the asset.
As demonstrated in the example below, it can show a higher return than the cap rate.
Let's assume that a property has a market value of $500,000 and $125,000 NOI. The capitalization rate will be 25% ($125,000 / $500,000). The capitalization rate assumes that it is an all-cash purchase and no financing is used.
The ROI takes debt into the calculation, which impacts returns. Let's suppose that the investor makes a down payment of $50,000 for the above property. The NOI remains at $125,000. The mortgage is interest-only and costs $5,000 a year.
According to the formula for ROI, the rate of return will be 240% where:
(Net Operating Income - Mortgage Interest) / Total Asset Value
(125,000 - 5,000) / 50,000
The total asset value, in this case, is the down payment. The return on investment can enhance profits and magnify losses due to leverage if negative events occur.
What Is a Good Cap Rate?
As mentioned above, the acceptability of a cap rate depends on various factors, including the investor's risk appetite. For example, one investor may consider a good real estate cap rate of 6%, while another may find it insufficient. The high cap rate compensates investors for their risk by investing in a specific property.
Usually, a cap rate in the 5-10% range is considered good.
However, cap rates fluctuate, and predicting where they will be in, let's say, ten years can be a challenging task, as a WSO forum user has remarked below. In addition, inflation can impact cap rates - the market values will increase while the cap rate will decrease, thus creating a cap rate compression.
You can't forecast cap rates the same way no one knows whether the stock market is going to go up/down/or sideways. Standard industry practice entry-exit spread is 50bps. Don't ask me where that comes from. Now, this is where the "art" part of acquisitions/underwriting comes in.
A standard industry practice requires a 50bps spread - that is, the cap rate when selling the property should be 50 basis points lower than the cape rate when the asset was purchased.
Value-add deals, which are real estate purchases that can be improved to generate more revenue and lower costs, could command a 10bps cap rate decrease per year. This increase is added to the current market cap rate.
Value-add deals occur when the asset is not stabilized. A property that is not stabilized means that it has higher tenancy vacancies, more expenses compared to similar properties, shorter leases, or lower rents. In this case, value add will create enhancements and efficiencies to improve revenue and reduce costs.
Using the Gordon Model for Capitalization Rate
The Gordon growth model (GGM), named after Myron J. Gordon, is a model that discounts the dividends that a company pays to its shareholders to their present value. It assumes constant dividend increases. It is similar to a DCF analysis but for dividends.
It is also known as a dividend discount model (DDM). It is used for calculating the intrinsic value of a stock.
The GGM can be useful for calculating the cap rate when a real estate has growing cash flows year over year.
The dividend discount model determines the value of a stock by dividing the projected annual dividend cash flows by the net return. The net return is obtained by subtracting the expected growth rate from the investor's required rate of return.
Stock Value = Dividend / (Required Rate of Return - Expected Growth Rate)
This formula resembles the cap rate calculation, where the property market value is the current stock value, and dividends would match the NOI. It follows that the cap rate will be the real estate investor's required rate of return minus the expected growth rate. The expected growth rate is the rate by which cash flows from the property will increase year over year.
Let's assume the following for a real estate investment with increasing cash flows. An investor buys a property with an NOI of $75,000 that grows at 2.5% a year. The investor's required rate of return is 8%.
Using GGM based on these parameters, the value of the property will be $1,250,000 = $75,000 / (8% - 2.5%).
The Gordon model assumes that cash flows, required return rate, and growth rate are constant. However, it is not certain that these variables will remain constant throughout the asset's holding; the model may prove inaccurate.