The capitalization rate, or “cap rate”, is one of the foundational concepts for talking about, evaluating, and understanding a real estate investment. It can be expressed simply as a ratio of the net operating income (NOI) to the fair market value or sale price of the property, typically calculated on an annual basis.
Cap Rate = Net Operating Income / Current Market Value
The inverse of this ratio – the fair market value divided by annual cash flow – shows the payback period, i.e. how many years it would take for a property to “pay for itself”. For example, a property purchased for $1 million that generates an annual net operating income of $50,000 would have a cap rate of 5%, and would pay off in 20 years. In practice, of course, neither NOI or market value of a property will remain constant, and thus the capitalization rate of any particular property will fluctuate over time.
Cap Rates Across Markets
The cap rate can provide a simple way to compare the performance of properties of a similar size in a similar location. However, prevailing cap rates vary substantially across markets for similar properties. A class A office building in New York or Los Angeles will typically carry a much lower cap rate than a class A office building in Detroit or St. Louis. This is due to market demand and the inherent risk in the property. Premier markets like Los Angeles or New York exhibit stronger market fundamentals – availability of high-paying jobs, workforce educational attainment, and demographic trends – and thus more stable cash-flow prospects and less vacancy risk. Therefore, investors in New York and Los Angeles are likely to accept lower cap rates for a similar property. Put differently, a higher cap rate for our hypothetical class A office property in Detroit reflects the “risk premium” an investor requires to purchase the property.
Limits of Cap Rates
While cap rates provide a good snapshot of current performance of a property, they should not be used in isolation to assess the overall return potential of two properties. Even similar properties in the same location likely carry different prospects for future cashflow. While a property’s value may be estimated by the use of, or expressed in terms of, a certain cap rate, this does not imply that its value is caused by the cap rate.
Cap Rate Alternatives
As discussed above, cap rates are a flawed instrument of measure due to the volatility of and difficulty in predicting future cash flows. It is prudent to look at other return measurements that help diversify this problem. One good alternative measure is yield on cost (YOC) which works very similarly to cap rates. The formula for yield on cost is market rent (the rent the property would receive if every unit was being rented at its full potential) divided by the total basis in the deal (the total amount of money put into the deal). Therefore, YOC is a great alternative to cap rates in properties because there is no dependency on predicting future cash flows/occupancy in the property as well as it being a more accurate metric due to it being a percentage of the total cost of the deal rather than just the purchase price.
Going-In vs. Going-Out Cap Rates
Real estate investment theses are predicated on an exit event, typically a sale. Projecting how net operating income will evolve between acquisition and sale of a property (or “hold period”) and how prevailing market cap rates will move, is key to projecting the expected overall return. The expected sale price of an asset at the end of a hold period, the primary component in determining the overall return of the project, is often very sensitive to minute shifts in the going-out cap rate (otherwise known as the terminal cap rate or reversion cap rate). Hence, real estate investors take great care in projecting this figure. It’s typically realistic to project a going-out cap rate equal to or higher than the going-in cap rate, all else being equal. This is because as buildings age, they usually become more risky and less able to sustain growing rents; this effect will be more pronounced the longer the hold (in other words, the more time elapses between the initial sale and the exit, where the going-out cap rate is projected).
Other factors in projecting going-out cap rates
- Market growth: if property’s market is expected to grow denser, more desirable, and/or more supply-constrained over the investment’s term, it’s reasonable to project a lower cap rate, all else being equal.
- Tenant lease situation: if one or more legacy leases are set to expire midway through a term, investors are wise to consider how the property’s rental prospects as those leases expire.