Cap Rate: Everything You Need to Know About This Commercial Real Estate Metric

Written by: Lucro Staff 10 months, 2 weeks ago

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What exactly is a real estate cap rate?

The capitalization rate, or cap rate, is one of the tools used to value commercial real estate properties.  Other methods include price per square foot, comparable sales, and the “cost approach”, where one estimates the cost of reproducing the subject property.  The cap rate, however, is arguably the most common property value assessment metric.  A property’s cap rate is the ratio of net operating income (NOI) to the property’s market value. Formulaically, one could define cap rate as the following:

Example: A 200,000 square foot luxury shopping center in picturesque San Francisco, California recently sold for $97MM. The mall, Haight-Ashbury Promenade, had an NOI of $4,850,000.

  

To unpack the value of the cap rate calculation, one must first understand the characteristics that separate seemingly similar properties.  Age, condition, location, size, floor plan, signage, and building amenities are some of the infinite traits that make one property worth more or less than another.  Cap rates are a function of all of these characteristics and the risks, opportunities, labor, and potential returns that the property possesses.  In the most simplistic terms, lower cap rates, which drive prices higher, indicate lower investment risk. With less risk comes less reward, however, so lower cap rate properties tend to produce lower returns. In contrast, higher cap rates, which drive property prices down, indicate a higher risk asset but provide potentially higher returns. 

 

How do I select a cap rate for a property?

Selecting the market cap rate for a particular property involves surveying the cap rates of comparable properties in the vicinity of the desired asset.  Because no two properties are exactly identical and real estate values fluctuate regularly, the “market” cap rate is ultimately a personal opinion. To illustrate this, let’s talk about a hypothetical fast food restaurant, Speedy Foods. 

You own a Speedy Foods property and would like to sell it. However, you’re unsure of its value. You know that the subject property generates $75,000 per year in net operating income. You also know the cap rates for 5 other Speedy Foods restaurants in the area, based on their NOI and what they recently sold for (remember cap rate equals NOI divided by property value).

You believe that fast food restaurants in the market are priced based on 2 factors that hold equal value: the presence of a drive-through and the location.  You prepare the chart below:

Property

Drive-through?

Location

Cap Rate

SUBJECT                    
(Speedy Foods location)

No

Subject

Unknown

Property A

No

Worse Than Subject

6.50%

Property B

Yes

Better Than Subject

5.00%

Property C

Yes

Worse Than Subject

6.25%

Property D

No

Worse Than Subject

7.00%

Property E

Yes

Same as Subject

5.25%

 

 Looking at the chart above, it’s unclear what insights we can gather as there is no property that’s identical to the subject property. Analyzing each property individually, you determine:

Property

Drive-through?

Location

Cap Rate

Findings

SUBJECT                           (Speedy Foods location)

No

Subject

Unknown

 

Property A

No

Less Than Subject

6.50%

Inferior to subject

Property B

Yes

Better Than Subject

5.00%

Superior to subject

Property C

Yes

Less Than Subject

6.25%

Comparable to subject

Property D

No

Less Than Subject

7.00%

Inferior to subject

Property E

Yes

Same as Subject

5.25%

Superior to subject

 

Through deductive reasoning and process of elimination, Property C’s capitalization rate appears to be most comparable to your subject Speedy Foods property. As such, the market cap rate of your Speedy Foods is likely around 6.25%.  Thus, it would be reasonable to deduce that the market value of your Speedy Foods as follows:

What other insights can I gather from cap rates?

Let's return to our case study of Speedy Foods.

Although four of the above properties were not great market comps, they do hold tremendous value in the assessment of the property’s value. 

Let’s conduct a sensitivity analysis to determine the effect of the presence of a drive-through and the location of the property on the asset’s cap rate.

Some things you need to know before we begin the analysis:

  1. A Sensitivity Analysis tests different inputs of an equation to see a range of outcomes.  The inputs and results are typically represented by a graph or chart.  In reference to the Speedy Foods example, our inputs would be the presence of a drive-through and the location of the property.  Our output would be cap rate.
  2. Basis points 101:
    1. What is a basis point? A basis point is one one-hundredth of a percent. One basis point is equal to 0.01% and 100 basis points is equal to 1.00%.
    2. Why are basis points important? Basis points are a common unit of measure for financial rates.

Both Property A and D do not have drive-throughs and have worse locations than the subject property.  These properties would be considered inferior as compared to the subject property and would be viewed as riskier to an investor.  This risk drives their cap rates higher, lowering the market value of the properties.  Because the price for properties A and D is lower than other Speedy Foods locations, certain investors may find them attractive because there is room to add value by building drive-throughs, which would lower the properties’ cap rates and increase the investor’s return.

An interesting nuance is the delta, or difference, between the cap rates for properties A and D.  Our quick analysis earlier in this article did not take into consideration that a location has degrees of desirability.  Property A’s 6.5% cap rate and Property D’s 7.0% cap rate are 50 basis points (bps) apart, demonstrating that, all else equal, Property A is in a more desirable location.

Now let’s compare Properties C and D.  Both are in a less desirable location than the subject property but only Property C has a drive through.  Property C has a cap rate of 6.25% while Property D has a cap rate of 7.0%. If one were to assume that the properties are in similarly-attractive locations and that the properties were otherwise identical, a sensitivity analysis would imply that adding a drive-through to a Speedy Foods location reduces the cap rate of the property by 75 basis points, equal to the difference between the cap rates of the two assets.

These insights can be helpful in multiple instances, such as if one were weighing the decision to purchase a property with or without a drive-through, where to purchase a property, or how much money to spend on the development of a drive-through at an existing site.  Furthermore, these insights could spur additional due diligence questions such as leasing rates, traffic counts, and average household incomes in the area.

 

Where do cap rates fall short?

In most cases, cap rates cannot be the sole valuation metric employed by an investor for a multitude of reasons.

Redevelopment, for example, can be problematic for cap rate analysis because the income and asset type of the subject property is often quite different from the proposed redeveloped property.  For example, a developer could create an apartment building on a lot of land that previously functioned as a car wash.  The cap rate of the car wash would not be particularly useful in determining the value of the future apartment building.

Utilizing cap rates on vacant properties or land is also not advisable as there is no in-place income. This makes using the cap rate formula difficult since the cap rate calculation formula requires an NOI.

Additionally, a forward-looking NOI is commonly used by sellers to boost a property’s sale price. Sellers most often craft a pro forma financial model that forecasts an increase in NOI and assumes a stable or decreasing cap rate, thus increasing the property’s value (remember property value equals NOI divided by cap rate). Sellers assume that the buyer will realize the modeled increase in cash flow and factor that value into their analysis.  Just like cap rates however, pro-forma financials are subjective and properties don’t always perform exactly as projected. Real estate assets are impacted by innumerable factors like demographic change, economic cycles, tax rates, or even catastrophic events such as hurricanes and earthquakes. By modeling the pro forma under best-case assumptions, sellers can skew the cap rate for their own benefit.  Thus, it is crucially important to have a flexible financial modeling solution that can show the profitability of the asset under a range of assumptions.

 

What 3 things about cap rates should I remember?

 1.. The formula for calculating cap rate is:

 2. The market cap rate for an asset is subjective, so it is important that you perform due diligence to ensure that the opinions and assumptions used to solve for a cap rate are reasonable.  A common way to verify your cap rate is  through creating a list of comparable buildings that have recently sold.

 3. Cap rates are inversely proportional to the asset’s value, meaning that lowering the cap rate increases the asset’s price and increasing the cap rate decreases price.  Cap rate is an indication of the potential return of an asset.  If the cap rate is higher, there’s a higher potential return because you’re taking on additional risk.

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