Capitalization Rates: Everything There is to Know
The capitalization rate (cap rate) is the golden metric of commercial real estate investing. Investors, brokers, and lenders use cap rates to describe investment properties and determine their market value. While cap rates are a simple concept, theoretically, they are full of nuance and complexity in a real-world application.
This blog post will serve as a guide to familiarize you with the basic terminology and dive much deeper into mastering cap rates, correctly using them in your deal analysis, and avoiding mistakes.
Table of Contents
Capitalization Rate Investment Metric
Generally speaking, a cap rate is simply a benchmark. It’s a way to classify a commercial real estate deal and determine its market value. I believe cap rates are used most effectively on commercial properties (retail, office, industrial, hotels) and apartment buildings with more than four units.
Rental property cap rates only work if there is scale. Cap rates aren’t effective on single-family homes or with duplexes, triplexes, or quadruplexes. The lack of units can lead to wild cap rate calculation results that don’t make sense if there’s any prolonged vacancy.
Cap Rate Calculation
There are only two variables needed to calculate a cap rate.
Cap Rate = Net Operating Income / Purchase Price
Note: Annual Net Operating Income (NOI ) = Cash flow before debt service and capital expenditures. On the revenue side, this would be primarily rental income. On the expense side, this would include your recurring operating expenses such as repairs, payroll, property management fees, marketing, utilities, property taxes, etc.
If you’re looking at a property with an $85,000 NOI and the pricing guidance is $1,600,000, you’d be looking at a 5.31% cap rate.
$85,000 / $1,600,000 = 5.31%
Cap Rate Formula Revised
Remember how I said a cap rate is primarily a benchmark? Often, an investor will receive financial statements for a potential real estate project and must determine a fair property valuation. If they are knowledgeable about the submarket and know a reasonable cap rate range for a particular asset class, this exercise is relatively simple.
For example, if you are looking at multifamily properties and aim to purchase a 6% cap, and you know the NOI, then simply rearranging the cap rate formula can solve the sales price.
Sales Price = NOI / Cap Rate
If the NOI is $75,000, making an offer of $1,250,000 would equate to a targeted 6% cap rate.
$75,000 / 6% = $1,250,000
Astute investors will study the sales comps, unearth the cap rates of these sales, and go into their deal analysis with a cap rate range in mind (much more on this process later).
Cap Rates & Investment Risk
The cap rate of a property correlates with its perceived riskiness in the investment community. Generally, low cap rates correlate with “safer” investments with modest profitability potential, while high cap rates correlate with higher risk but with the potential for an outsized rate of return. “Risk” could be a multitude of factors:
Location: An apartment building in Fargo, North Dakota, is going to be riskier than an apartment building in Seattle, Washington, and if the two properties were identical in both markets, the North Dakota property should sell at a higher cap rate due to its remote location, smaller population, fewer jobs, etc.
Asset Type: A retail investment strategy is riskier than multifamily and generally sees higher cap rates. An example would be a retail investment that hosts a restaurant much more susceptible to a recession than an apartment complex and should be valued with a higher cap rate.
Asset Class: A luxury apartment building built within the last five years is a safer investment than a building built 100 years ago. Given its newness and desirability with all the recent amenities, it should have a lower cap rate.
If you become a real estate market expert in a city or submarket, you’ll know how the neighborhoods, building age, and property condition all impact the value of a property and their “likely” cap rate if they were to sell.
Determining a Good Cap Rate
Higher cap rates favor real estate investors looking to purchase a property. For example, If you are looking for Class “B” apartment buildings in Jacksonville and know the property values range from 5.00% to 5.25% cap rates, you’d be thrilled if you won a listing for a 5.50% cap.
Paying a higher cap rate than similar properties sold will give you a better chance to maximize return on investment, thanks to a higher likelihood of appreciation due to lower initial investment, smaller mortgage payments, and more cash flow.
Determining a reasonable cap rate requires precise research and analysis techniques. I break it down into five steps:
Studying cap rate surveys
Researching pertinent sales comps
Adjusting the property NOI to smooth out any anomalies in operations
Assessing deferred CAPEX and operating upside
Reevaluating the cap rate after completing steps the first four steps
Without a standard set of procedures, it’ll be challenging to find helpful pricing insights and decipher the “good” cap rates from the “bad.”
Residual Cap Rates
Cap rates also play a significant role in DCF analysis. One of the essential assumptions you make revolves around the future sales price of your investment, which is determined by a residual cap rate assumption.
Selling Property
Imagine you are purchasing a property for a 4.75% cap rate. You are modeling a 10-year investment hold. In Year 10 of the proforma, you need to consider how much you could potentially sell the property for.
What would a future buyer pay for your property in cap rate terms? Would it be a 5.50% cap rate? A 5.75% cap rate? Conservative underwriting will have a more considerable (and higher) spread between the going-in and residual cap rates. The higher the residual cap rate you use, the more conservative your underwriting is.
Residual Cap Rate - Going-In Cap Rate = Cap Rate Spread
The larger the cap rate spread, the more conservative the underwriting, as the asset value at sale, is less crucial, and cash flow takes more precedence in making the deal work.
Generally speaking, I have observed a 0% to a 1% spread in the residual cap rate and, most commonly, a 0.50% increase. However, I’d argue that 0.50% isn’t insufficient when the Federal Reserve aggressively raises interest rates to hamper inflation.
Realistically, it’s impossible to guess the property’s value ten years into the future. However, whatever cap rate you use, you’d take the property’s net income in Year 11 and divide it by the residual cap rate to determine the gross sale proceeds. You’d then subtract out closing costs and brokerage fees.
Higher Residual Cap Rate = Lower Risk.
Cap Rate Weaknesses
While cap rates are the most commonly recited investment metric for all commercial property types, there are some shortfalls you must consider:
Biased sales comps
Broker manipulation
Buyer motivations
Varying financing options
CAPEX
I wrote an article about how cap rates can be misleading, and I spent time describing the bullets above and how you need to take quoted cap rates with a grain of salt until you can research and verify.
Realistically, cap rates are just one metric you can use when evaluating commercial real estate, and their simplicity leaves them vulnerable to manipulation. I always recommend you use multiple investment metrics when considering a potential investment in tandem with cap rates, such as:
Price/Unit (compared to comps)
Price/Square Foot (compared to comps)
Replacement Cost (compared to Purchase Price + Renovation Cost)
This way, you’ll have a much more robust analysis. If the property's value feels fair from a cap rate perspective, some of these other metrics may unearth other weaknesses that need to be addressed that would limit potential returns.
Advanced Cap Rate Strategies
In the same article that explains why cap rates can be misleading, I also cover some advanced uses of the cap rate metric in your investment analysis that go beyond the basic definition. These three strategies are:
Understanding the cap rate spread
Stressing the residual cap rate
Comparing the cap rate to the loan constant
At the surface level, quoted cap rates may not offer much insight. However, reconfiguring and using them “outside the box” can create tremendous wisdom.
Cap Rate Spreads
I don’t look at just one cap rate. I get as much information as possible by looking at as many cap rates as possible for historical periods and what I am projecting for future periods. Most commonly, I will look at the cap rate on the trailing 12 financials and then compare it to the cap rate on my projected Year 1 of the proforma (that has been adjusted for property taxes).
Note: Reassessment of property taxes can have a massive impact on your cap rate calculation.
Suppose the proforma cap rate is higher than the cap rate on the historical financials. In that case, you’ll be taking on more risk as the new property owner (ideally, you’d want the cap rate to increase when you take over as you grow the NOI through improved operations). I’ve seen many deals that look like a 5% cap, but once adjusted for increasing property taxes, that 5% cap widdles down to a 4.5% cap. Be careful!
Stressing Residual Cap Rate
We already discussed residual cap rates and how they can impact a proforma. Tactica financial models allow you to stress the residual cap rate easily to see how a higher residual cap rate will impact total returns.
Cap Rate-to-Loan Constant
Comparing the cap rate to the loan constant can provide valuable insight.
Cap Rate > Loan Constant = Good
Cap Rate < Loan Constant = Bad
The loan constant is the total annual principal and interest payment divided by the total loan amount.
If the cap rate is less than the loan constant, you’ll experience negative leverage until you can increase monthly rents or cut expenses. In other words, debt is hurting your annual yield on investment. You’d have been better off purchasing the property without any debt.
Ideally, the cap rate will be higher than the loan constant, and the leverage provided by your real estate loan will enhance your annual cash-on-cash returns.
The constant comparison of cap rate-to-loan has been one of the leading investment decision drivers for me when determining if it’d be wise to invest as an LP in a GP-sponsored project.
Summarizing Cap Rates
Cap rates are the first investment metric in commercial real estate. You can use them to describe qualitative and quantitative investments that correlate with risk.
A surface-level understanding of cap rates is easy. Deep knowledge, avoiding pitfalls, and advanced analysis techniques will take time and volume to master but will prove invaluable in a competitive commercial real estate investment world. Resources and ideas to maximize cap rate data are all included in this article and should be revisited frequently.
