Cap Rate Definition
The information noted below was prepared only as an example.
Please note the rates reflected are not indicative of current market cap rates as commercial and industrial properties have appreciated tremendously in the past two to three years.
What is a cap rate? Cap rate is a very important term and calculation used in commercial real estate. Cap Rate or the capitalization rate, is the ratio of Net Operating Income (NOI) to the property asset value. For example, if a property sold for $2,000,000 and had an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 5%. In the Current Market cap rates are in the 2 to 4 % rate in the Toronto Commercial Real Estate Market.
Cap Rate Example
Using this example we discover that a recent sale of an office building with a Net Operating Income (NOI) of $7,000,000, and a sale price of $35,000,000. The this commercial property sold at a 2.0% cap rate. That may not be high. But Commercial Real Estate Valuation is not only Cap Rate. There is also the potential appreciation of the Commercial Real Estate Property.
Thoughts behind the Cap Rate
What is the purpose of the cap rate. What does it indicate to the potential buyer. Investors look at the cap rate or the return on investment. It also creates a common ground to compare to other commercial properties. For example the sector. Multi-Residential Properties what would the rate of return be for one Apartment Building vs and another Apartment Building. As no building is exactly the same as another. It is a reasonable factor to compare. Another way of thinking of cap rate is that it is inverse of the price/earnings multiple. Consider the following chart:
As shown above, cap rates and price/earnings multiples are inversely related. In other words, as the cap rate goes up, the valuation multiple goes down.
What is Reasonable Good Cap Rate?
What’s a good cap rate? This is a difficult Question to answer. Based on current interest rates of One Year T-Bill would be a good guide to compare to. However the Cap Rate is not the only factor to guide an investor to buying a building.
An investor will use the market cap rate to compare with other available properties for sale. In this case, a good cap rate is one that is derived from similar properties in the same location. For example, suppose you want to figure out what an office building is worth based on a market-derived cap rate. In this case, a good cap rate is one that is derived from recent office building sales in the same market. A bad cap rate would be one derived from different property types in different markets.
Best way of using the Cap Rate Ratio
The cap rate is a ratio used extensively in the commercial real estate industry and it can be beneficial in several ways to making a decision. The cap rate is used for a quick assessment during the due diligence period or simply to compare to other properties or to the current bench mark cap rate. The cap rate can and be used to access if a interested acquisition is worth to be considered for a future purchase. A 4% cap rate acquisition versus a 6% cap rate acquisition for a similar property in a similar location can quickly tell you that one property has a higher risk premium than the other.
Another way the calculation of a cap rates can be helpful is when they form a trend. If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed. For instance, if cap rates are compressing that means values are being bid up and a market is heating up. Where are values likely to go next year? Looking at historical cap rate data can quickly give you insight into the direction of valuations.
While cap rates are useful for a quick back of the envelope calculations, it is important to note when cap rates should not be used. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation.
Components of the Cap Rate
What are the components of the cap rate and how can they be determined? One way to think about the cap rate is that it’s a function of the risk-free rate of return plus some risk premium. In finance, the risk-free rate is the theoretical rate of return of an investment with no risk of financial loss. Of course, in practice, all investments carry even a small amount of risk. However, because U.S. bonds are considered to be very safe, the interest rate on a U.S. Treasury bond is normally used as the risk-free rate. How can we use this concept to determine cap rates?
Suppose you have $10,000,000 to invest and 10-year treasury bonds are yielding 3% annually. This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks. What if you were presented with an opportunity to sell your treasuries and instead invest in a Class A office building with multiple tenants? A quick way to evaluate this potential investment property relative to your safe treasury investment is to compare the cap rate to the yield on the treasury bonds.
Suppose the acquisition cap rate on the investment property was 5%. This means that the risk premium over the risk-free rate is 2%. This 2% risk premium reflects all of the additional risk you assume over and above the risk-free treasuries, which takes into account factors such as:
- Age of the property.
- The covenant or credit ranking of the tenants.
- The diversity of the tenants.
- Length of tenant leases in place.
- Broader supply and demand fundamentals in the market for this particular asset class.
- Underlying economic fundamentals of the region including population growth, employment growth, and inventory of comparable space on the market.
When you take all of these items and break them out, it’s easy to see their relationship with the risk-free rate and the overall cap rate. It’s important to note that the actual percentages of each risk factor of a cap rate and ultimately the cap rate itself are subjective and depend on your own business judgment and experience.
Is cashing in your treasuries and investing in an office building at a 5% acquisition cap rate a good decision? This, of course, depends on how risk averse you are. An extra 2% yield on your investment may or may not be worth the additional risk inherent in the property. Perhaps you are able to secure favorable financing terms and using this leverage you could increase your return from 5% to 8%. If you a more aggressive investor this might be appealing to you. On the other hand, you might want the safety and security that treasuries provide, and a 3% yield is adequate compensation in exchange for this downside protection.
Band of Investment Method
The above risk-free rate approach is not the only way to think about cap rates. Another popular alternative approach to calculating the cap rate is to use the band of investment method. This approach takes into account the return to both the lender and the equity investors in a deal. The band of investment formula is simply a weighted average of the return on debt and the required return on equity. For example, suppose we can secure a loan at an 80% Loan to Value (LTV), amortized over 20 years at 6%. This results in a mortgage constant of 0.0859. Further, suppose that the required return on equity is 15%. This would result in a weighted average cap rate calculation of 9.87% (80%*8.59% + 20%*15%).
Allen Mayer, Commercial Realtor