If you are looking to acquire a commercial real estate property, it is crucial to understand how to come to an appropriate purchase price that is competitive but doesn’t overvalue the property. The most common way to do this is by using a capitalization rate, or cap rate.
Definition and Formula
The cap rate is the percentage at which you divide the projected net operating income for the next year in order to arrive at a market value for a property. The equation for this is shown below.
Let’s go through a quick example for this below. You are considering investing in a multifamily property that had $1,000,000 in net operating income last year. You believe you can increase that NOI by 3% for the upcoming year through increases to rent. The owner is asking for $18 million for the property, and deals for similar properties in the area have been done at an average cap rate of 5.00%. Should you purchase the property?
As mentioned, you believe you can grow the $1 million NOI by 3%, which becomes $1,030,000. When you divide this by the asking price of $18 million, we get a cap rate of 5.72%. The market cap rate for similar properties is 5.00%, so it is clear that this purchase price is a good deal for the buyer.
The buyer is always hoping to buy a property at a higher cap rate, and the seller is always hoping to sell a property at a lower cap rate. The cap rate is showing you your unlevered cash yield for the first year, so the benefits of achieving a higher cap rate as a buyer are clear.
What is a Good Cap Rate?
Required Rate of Return Method
Cap rate is a quick and easy calculation, but it can be difficult to understand how a market arrives at cap rates for different property types and properties of varying quality. We are going to go over an example to give you a better understanding of how to arrive at an appropriate cap rate. If you have read our Internal Rate of Return article, this will all sound familiar.
You are debating whether you want to invest in corporate bonds or commercial real estate. The corporate bonds you are looking at will yield a 7% return, and with the risk of real estate being slightly higher, you want to achieve an unlevered IRR of 8% in order to compensate for the added risk.
You are projecting the F-12 NOI to be $1 million, and the seller is willing to sell the property for $20 million. You expect to be able to grow the NOI and property value by 2.5% each year. Based on your required rate of return, should you purchase the property for $20 million?
Your return is comprised of the initial yield and the annual growth rate. The initial yield is your cap rate, which we find by dividing the projected NOI of $1 million by the sale price of $20 million. When you do this, you get a cap rate of 5.00%. After adding the annual growth rate of 2.50%, you can expect to achieve a rate of return of 7.50%. This is less than your required return of 8%, so you should not purchase the property.
It’s important to tackle cap rate from a couple angles. We’ve discussed how you can analyze a deal based on a set return you are hoping to achieve, but it is also important to know what the market cap rate is for different property types and locations.
Market Cap Rate Method
It is great if you are able to meet your required rate of return on a deal, but you need to know if you are leaving money on the table. If comparable properties in the area have recently sold for cap rates of 5.50%, then you are probably overpaying at a 5.00% cap rate, which means you are going to be underperforming what you could be getting by 0.50%. If you continue doing this, you will underperform competitors and might face additional challenges trying to raise funds from investors.
If you’re a real estate investor, you are always going to be looking at deals. You can’t just stop investing for a few years until conditions get to where you want them. When there is capital to be deployed, you need to deploy it. This is why it is crucial to not view things in the bubble of your company and to make sure that you have a full view on the current overall market so you can maximize your earnings.
How is Market Cap Rate Determined?
Like every asset, the price a typical buyer will be willing to pay is determined by supply and demand. Each buyer has their own unique circumstances that determine what they would be willing to pay for a property. Furthermore, each market has its own set of benefits and challenges that investors will consider when determining the value of real estate in that area. Below are some of the common market attributes that investors will consider.
• Median income
• Median age of population
• Educational attainment of workforce
• Employment rate
• Growth rate of population
• Current and projected supply of property type
This isn’t an exhaustive list, but it does show what is important to investors. A growing, well-educated, young population with positive job prospects and low supply will generally attract investors. These positive dynamics mean investors will likely be able to increase rents over time more than in other markets, so cap rates will decrease and properties will become more valuable.
NOI CapEx Adjustments
It is important to mention a common adjustment made by some people within the real estate investing community, which is to include capital expenditure reserves in the net operating income. I want to be perfectly clear, capital expenditures are not part of net operating income. However, some real estate professionals include capex reserves in NOI for underwriting because capital expenditures do come up and they do cut into cash flow.
It’s unfortunate that this adjustment muddies the water a bit, but it is understandable why people would want to include it in the formula. It is money that needs to be spent and it does lower your cash flow and returns. Commonly, you will see lenders include capital expenditures in NOI because they are greatly concerned with monthly cash flow. They want to make sure you have ample cash to pay your debt service, so including capital expenditures in NOI makes sense from their perspective.
Whether you choose to include capital expenditures or not is up to you, but even if you don’t, it is always important to keep capital expenditures in mind. Older properties with outdated appliances will require more annual capital expenditures to keep the property in good condition, so even if you are buying these types of properties at higher cap rates, the capital expenditures will eat into that higher cash flow.
Problems with Cap Rate
Cap rate is not a bulletproof metric. There are many situations where you would be better off using a different valuation technique like discounted cash flow. The benefit of cap rate is its simplicity, but because of this, there are situations where it might not make sense.
Non-Stabilized Properties
Cap rate is the cash yield you expect to get in the first year of owning the property. This is a valuable figure to know in most cases, as it represents your unlevered return. There are situations where an investor will purchase a property before it is stabilized. This is common with new developments and underperforming value-add opportunities.
The problem with this is that your first-year yield is not going to be representative of your unstabilized returns as you lease more units. Let’s show a quick example below.
An investor purchases a newly built multifamily building for $20 million. The property is 20% leased, and by the end of the first year of ownership, the property is expected to be up to 80% occupancy. Based on these assumptions, you project the NOI for the first year to be $500,000. This equates to a cap rate of 2.5%.
A stabilized property is not going to be selling at a 2.5% cap rate because that is far too low of an unlevered first-year return, even with generous growth projections for future years. You aren’t able to compare this cap rate to other projects since it is almost meaningless. A property needs to be stabilized for the cap rate to be a metric that you can compare among similar properties in the area.
Large Capital Expenditures
Many investors buy what are called “value-add” properties, which are older properties with outdated finishes and amenities, and then renovate everything so they can achieve higher rents and increase the value of the property. In these situations, the cap rate at which you purchase the property doesn’t tell you a lot about whether the investment is worth it.
We have discussed that the cap rate is the unlevered yield for the first year, but in the situation I’ve described, you will not be continuing the operations of the property, so this will not be your unlevered yield. The NOI is not going to be similar because after the improvements it should be quite a bit higher, and the purchase price does not mean much alone because you will also be spending significant amounts on capital expenditures to renovate.
Conclusion
Cap rate is the most popular method for analyzing commercial real estate because of its simplicity and ability to be used for comparing similar properties. There are some minor issues, but for stabilized properties it is a great metric for understanding your potential returns.
We hope you have enjoyed learning about the capitalization rate. Be sure to check out our other articles on real estate investment metrics to help you gain a full understanding of valuating properties.