Summary:
Cap rate is a common return metric used to evaluate real estate investments
Cap rate provides a pro forma unlevered yield from a real estate investment
Cap rate can be utilized to impute the pay back period from a real estate investment
Cap rates can be used to quickly interpret investment risk
Similar to other investment metrics, cap rate has shortfalls and should be used in combination with other metrics to form a well-rounded analysis
Cap rates can have a significant impact on pro forma exit values and pro forma returns
Cap Rate Formula:
Cap Rate = Year 1 Forecasted Pro Forma Net Operating Income (NOI) / Property Value
Cap Rate Definition:
Capitalization rate, typically shortened to cap rate, is a common return metric used to evaluate real estate investments. The cap rate computes a percentage yield a property generates (NOI) utilizing the property value as a cost basis. The cap rate can be viewed as a pro forma unlevered investment yield as net operating income (NOI) is income generated from the property before debt service.
Cap Rate Importance:
The cap rate provides a quick and easy to understand metric to pro forma investment returns. The formula 1/cap rate provides the unlevered payback period of the investment. For example, a 10.0% cap rate property is a 10 year unlevered pay back. Cap rates also imply risk. Typically a low cap rate property will have lower risk and lower return than a high cap rate property.
Cap Rate Shortfalls:
Although cap rate is a useful metric for quickly screening investment opportunities, it does not contemplate time value of money, capital stack, operating results beyond year 1, and capital improvements. The details of each shortfall are summarized below:
Time Value of Money: Cap rate is computed as year 1 forecasted pro forma NOI / property value and does not incorporate an investment time horizon or discounting. This means that cap rate will not tell you if a property is better than another over a longer investment time horizon.
Capital Stack: Cap rate utilizes year 1 forecasted pro forma NOI, which is a before debt service cash flow, as the cash flow in the yield calculation. This means that cap rate will not provide an accurate and easily understandable return metric if debt will be utilized in the investment.
Operating Results Beyond Year 1: Cap rate only considers the year 1 forecasted pro forma NOI and does not consider NOI beyond the first year. This means that cap rate will not incorporate operating improvements captured in NOI that incur beyond the first investment year.
Capital Improvements: Cap rate will typically use property value or purchase price as the denominator in the calculation. The calculation varies with some analysts including immediate capital expenses in the property value, but many will exclude capital expenses in order to make deals pencil. In addition, cap rate will not include capital expenses incurred throughout the investment hold period.
Cap rate is best used as a component within real estate investment analysis alongside more comprehensive calculations, such as unlevered IRR, levered IRR, and multiple of capital, rather than as the sole return analysis metric.
Cap Rate Example:
Imagine a situation where a real estate investor has an unlimited amount of capital and is tasked with purchasing a property that will generate the highest possible return. The investor is making a decision between the following 3 real estate investment opportunities:
All three of the properties are multi-family, 300 units, and 300,000 total square feet for average unit size of 1,000 square feet. The key differentiating factor amongst the three properties is the location. Property 1 is in Manhattan, NY, which is a tier 1 city, property 2 is in Denver, CO, which is a tier 2 city, and property 3 is in Detroit, MI, which is a tier 3 city. Reflective of the location differences, property 1 is more expensive than property 2 and property 2 is more expensive than property 3. In addition, property 1 has a higher pro forma NOI than property 2 and property 2 has a higher pro forma NOI than property 3. An investor focused only on cap rate might be drawn to property 3 as it has a higher pro forma cap rate, thus a higher pro forma investment return.
This may not be the best decision as property 1 and property 2 most likely are lower risk than property 3 and also will have better growth prospects and upside potential given they are in more desirable cities. The low cap rate of property 1 could be viewed as a better valuation and risk adjusted pro forma return. The higher cap rate of property 2 could be viewed as lower potential upside and lower pro forma return over the investment time horizon.
Cap rate is a useful analysis metric, but investors are challenged with the interpretation of cap rates and determining what an appropriate cap rate is for their investment objectives and compared to target markets. It is best to get information from brokers and research reports to determine what market cap rates are. In the above example, if market cap rates for Manhattan, NY are 3.0% and market cap rates are 7.0% in Detroit, MI, property 1 is an attractive opportunity and property 3 is not an attractive opportunity.
Cap Rate Exit Impact:
Cap rate exit assumptions have a significant impact on pro forma returns. The goal is to always sell properties at a cap rate lower than the purchase cap rate. This is known as cap rate compression. From a high-level, 1/cap rate provides an NOI multiple to calculate asset value. For example, $1 of NOI at a 5.0% cap rate is equal to $20 of property value and $1 of NOI at a 4.0% cap rate is equal to $25 of property value. The chart below illustrates the cap rate impact on exit value and returns:
The above example shows that all else equal, increasing cap rates on exit results in lower pro forma returns, while decreasing cap rates on exit results in higher pro forma returns. This is a key consideration when preparing pro forma models as a significant portion of the pro forma return will be derived from the exit cap rate assumption.
If an investor is able to increase NOI through their hold period while market cap rates compress, there is potential to make outsized investment returns.
Pro Forma Models has highly experienced real estate private equity professionals on staff that have developed affordable institutional-quality real estate investment models that include cap rate calculations. Some of our most popular real estate models are:
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