What are Cap Rates and what do they tell us?
A Cap Rate (capitalization rate) is a simple and fundamental valuation metric used in commercial real estate. It is calculated by dividing Net Operating Income (NOI) by the Purchase Price for a given asset and is expressed as a percentage.
Net operating income is the sum of all operating revenues minus all operating expenses. What is not included in net operating income is capital expenditures and principal and interest payments associated with your mortgage.
Here is an example of an income statement that shows the net operating income of a fictional property:
Purchase price is straight forward. It’s the price at which you are able to acquire the property. In the cap rate calculation, you do not include transaction costs. Other metrics, such as “NOI Yield,” do take transaction costs and capital expenditures into consideration, and these metrics are discussed in our Financial Metrics article.
Continuing our example above, let’s assume we can buy this property for $12,500,000. At this purchase price, our cap rate is 6.08%; colloquially referred to as a “low 6 cap."
So, what do cap rates tell us and how do we use them? A cap rate tells us what Net Operating Income is as a percentage of the purchase price. In our example above, our net operating income of $760,000 is 6.08% of our $12,500,000 purchase price. Looking at a property’s income from this perspective allows us to see and compare its relative expensiveness to other potential acquisitions.
Let’s assume the property in the example above is located in Denver, CO, and we build and lease an exact replica in Cleveland, OH. These are two very different markets with very different market dynamics. Denver is growing and producing jobs at an exceptional rate, and people in Cleveland are moving to Denver to get their slice of the prosperity. Denver has a positive net migration rate, meaning more people are moving into the area than out of the area, and Cleveland has a negative net migration rate. Because of these population and job growth dynamics, rents in Denver are very likely to increase while rents in Cleveland are likely to remain idle or even slump. Where would you rather invest your capital? What market has greater certainty of principal protection and appreciation? Denver does, so an investor is willing to pay more to invest in that market.
Because of the differences of these markets, while an investor is willing to accept an NOI that is 6.08% of the purchase price in Denver, they might require a net operating income that is 8.08% of the purchase price in Cleveland, which calculates a purchase price of $9,405,941.
Using simple algebra to manipulate our Cap Rate equation, we divide the NOI by the desired cap rate to solve for Purchase Price.
This demonstrates an important characteristic of cap rates. Cap rates have an inverse relationship to price. A lower cap rate means a higher relative price. As you can see in our example, at a 6.08% cap rate, the property is valued at $12,500,000, but at an 8.08% cap rate, the property is only valued at $9,405,941.
Now let’s assume you have two different properties that are both located in Denver. One property is a retail shopping center with an NOI of $1,500,000 and the other property is a multifamily apartment community with an NOI of $1,000,000. Which property is likely to have the lower cap rate or be relatively more expensive?
Multifamily apartment communities are considered to be very low risk. Everyone needs a place to live so occupancy is usually quite high. If market rents are increasing rapidly, multifamily assets, with typical 12-month leases, allow owners to frequently sign and renew leases at the prevailing market rents. Multifamily assets also do not require much capital investment when you transition from one tenant to the next. You can usually make a unit ready for your next tenant for a few hundred dollars.
Retail shopping centers on the other hand are much riskier investments than multifamily communities. Not everybody needs retail space and demand for it is shrinking. Shopping centers have an uncertain future with a large and growing number of retail purchases happening online. Additionally, releasing retail space requires a massive amount of capital investment. A typical 1,200 square foot retail space may require $30/square foot, or $36,000, of capital investment to make it ready for the next tenant. These leases are typically for multiple years, but if the tenant isn’t credit worthy or doesn’t have strong operational history, who knows if they’ll be in business at the end of their lease. If they aren’t, you’ll likely need to invest additional capital to release it again.
The shopping center is clearly the riskier investment and because of this additional risk, an investor will require a higher immediate return in the form of a higher cap rate. Let’s assume the market determines that there is a 200 basis-point spread between the multifamily cap rate of 5.00% and the shopping center cap rate of 7.00%.
In this example, it will require an additional $1,428,571 of capital to purchase the retail shopping center. However, the multifamily community is relatively more expensive because each dollar invested will earn less in NOI. A dollar invested in the multifamily community will return 5%, whereas a dollar invested in the shopping center will return 7%.
Cap rates are always unlevered, meaning they do not consider how much debt is used to acquire the property. This enables investors to look at all properties from the same perspective; the perspective of operations. Different buyers have different access to capital which can dramatically change the levered returns of a property. By only looking at operations, we can more easily compare one property or market to another since we are only considering the property’s ability to produce income from operations.
Cap rates theoretically take all available market and property information into consideration and bake it into one number. The conditions of the market and the subject property will determine what immediate return from operations investors require. It is not the holy grail of valuation metrics; that metric doesn’t exist. You need to look at numerous quantitative metrics in concert with qualitative information and context in order to develop an accurate understating of an asset. However, cap rates give us a good perspective for relative pricing and allow us to quickly compare the risks and returns of different assets and markets.
Bonus Round!
If you take the inverse of the cap rate equation (flip the numerator and denominator) you get the following equation:
Does this look familiar? If you’ve ever looked at valuation metrics for stocks, you surely came across the Price Earnings Ratio or PE Ratio. A cap rate is just a PE Ratio flipped on its head and vice versa.
Let’s consider an asset that costs $1,000,000 to purchase and produces $50,000 a year in earnings.
A PE Ratio of 20 means the purchase price of an asset is twenty times its earnings. Expressed as a cap rate, the asset earns 5% of its purchase price.
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