In REPE investment, when analysing a potential commercial property acquisition, investors will, invariably, look at the expected return or income which can be obtained from such investment.
There are a variety of terms and phrases in use when it comes to reviewing such returns and it’s important to have a good understanding of such terms as these may be critical to being a successful investor!
Certainly, one of the important metrics for the assessment of investment opportunities is the capitalisation rate(s) (“cap rate(s)”), so let’s examine what cap rates are all about.
What is a Capitalisation Rate?
When investing money into commercial real estate the return on investment (“RoI”) generated is usually called “cap rate” or “investment yield”. This metric is expressed as a percentage and is one of the most important initial measurements which investors need to be aware of.
A higher cap rate indicates that the expected returns from a property are riskier and, accordingly, an investor is usually willing to pay less for such property. A lower cap rate represents a less risky property and, so, an investor is willing to pay a higher price and receive less yield.
The cap rate is calculated based on the net income which the property is expected to generate and is calculated by dividing Net Operating Income (“NOI”) by the current value of the property, expressed as a percentage.
Comparing cap rates is one of the easiest, preliminary ways to assess whether or not an investment deal is worth pursuing, although they are not 100% accurate and are used to estimate a potential return on investment, and can later be supported with due diligence detailed analysis.
Can Cap Rates change?
In fact, it is one of the aims of REPE investors to change the cap rate in order to enhance the value of the property. The process is sometimes referred to as “compressing cap rates” and involves acquiring a property for at or below market value and renovating it to boost the overall NOI, either following renovations to increase rental or to simply “value-add” and undertake renovations to raise the property value.
There are two sub-sets of cap types as follows:
Entry Cap Rate or “Going-in cap rate”: refer to the cap rate or passing yield at which an investor may acquire a property before undertaking some improvements, either to the operating performance or by renovation or otherwise enhancing the physical property
Exit Cap Rate: is the, clearly the cap rate at which the investment property is refinanced to sold, thereby realising the capital gain. It is not unusual for experienced sponsors to underwrite cap rate expansion so that the projected exit cap rate is greater than the entry cap rate on purchase
Typically, the cap rate will be expanded by around 5bps (.05%) per year to account for uncertainty which may relate to a specific property or the asset class as a whole, future capital expenditures not shown in the pro forma, and so on.
Investors will usually critically examine the relationship between the going-in cap rate and underwritten or estimated exit cap rate as this will give a broad overview of the likely profitability of the investment.
Application of and recognised formula for determining Cap Rates
Investors will use cap rates in their analysis when considering acquiring property and also when reviewing whether to sell a property.
As the cap rate formula works with properties where there is an annual NOI, it would, obviously, not be useful when assessing vacant land or property where there is no income being produced.
Typically, cap rates are used, therefore, for multi-family rental properties, apartment buildings, single-family rentals and most forms of commercial real estate such as offices or retail spaces.
As well as looking at the initial yield of an investment property, the cap rate can also indicate the number of years it will take for the investor to recover its initial investment.
The basic formulas for the computation of a capitalization rate are as follows:
- Capitalisation Rate = Net Operating Income divided by Current Market Value
The net operating income is the annual income generated by the property from rentals or other services provided. From this are deducted all expenses incurred in operating or managing the property. These will include the costs for maintenance and repair of the property, staff costs, marketing and utility costs as well as operating insurance and property taxes.
The current market value of the asset is the present-day value of the commercial property in question and is based on up-to-date market evidence of actual transactions.
Another option sometimes used is when the cap rate calculation is based on the original capital cost or the acquisition cost of a property as follows:
- Capitalisation Rate = Net Operating Income divided by Original Purchase Price
However, being based on historic acquisition cost this version may give unrealistically high percentage returns for properties which were purchased many years ago at relatively low prices. Furthermore, if a property was acquired at no cost such as via inheritance, then the calculation is unworkable as the acquisition cost is effectively zero.
Of course, where based on evidence of other transactions of similar properties, a cap rate is known, the formula can be changed slightly to derive the capital value of the asset. That is:
- Current Market (Capital) Value = Net Operating Income divided by Cap Rate
There is, therefore, an inverse relationship between cap rates and the figure used to capitalize the net income (sometimes called a “multiplier”) in order to derive the current market value of a commercial investment property.
Whilst used as a preliminary assessment of the return on investment for commercial property, there some key points to be noted about cap rates:
- a cap rate indicates the investment yield of a property over a one-year time horizon. Obviously, a property has a life expectancy and income stream over many more than one year so more sophisticated methods need to be employed to effectively analyze investment returns.These may include techniques such as a 10-year discounted cash flow (“DCF”) analysis or an Internal Rate of Return (“IRR”) to calculate work out a formal statement of value of a commercial property;
- assume the property is purchased for cash or 100% equity and without the benefit of a loan (this is sometimes called “unleveraged” vs “leveraged”);
- are a relatively simple calculation of a property’s intrinsic, natural, and unleveraged rate of return.
Clarifying the difference between a Cap Rate and ROI
The main difference between the two metrics is in what they are used for.
Cap rates help estimate an investor’s potential ROI, and give an indication of the likely returns investment. However, they serve a different purpose when analyzing a deal.
The ROI figure will provide an investor with an objective percentage of the return they can expect to make on a certain deal in percentage terms. It enables investors to compare the ROIs of two different types of assets.
The cap rate, on the other hand, is used to compare the returns from similar real estate assets.
What factors affect the selection of cap rates?
Key risk factors which affect the selected cap rate include:
- property type – multifamily, office, retail, industrial or hospitality;
- age, location, and nature of the property;
- duration and structure of tenant’s lease(s);
- the overall market rate of the property and factors affecting its valuation;
- macroeconomic fundamentals of the area as well as factors impacting tenants’ businesses on a regional or national or international basis;
- quality of tenants and frequency regularity of cashflow;
- the expected period of time it will take to recover the invested amount in a property. For instance, a property showing a cap rate of 10% will take around 10 years to recover the investment.
Why do cap rates vary between different commercial property types?
As the perceived risks in the security of the cashflow differ between different property asset classes cap rates naturally value with, say, residential cap rates differing from commercial property cap rates. However, cap rates also vary between different types of commercial property such as multi-family homes, offices, retail, warehouses, factories etc.
As mentioned, cap rates reflect risk and the security or certainty attached to an income stream and as referred to above, there are many factors which need to be taken into account, with the best evidence being that produced by actual sales of similar property.
For example, in challenging economic times the income stream from a grade A office block in a prime location with tenants on 10, 20 year or even longer-term leases is rather more secure than that of a five-star 300 room hotel which runs on daily occupancy basis.
Furthermore, most of the operating expenses of the office will be recoverable from tenants via the building management service charge, whereas a hotel has to spend marketing dollars every day to attract new guests, as well as pay key staff to operate the hotel no matter whether occupancy is high or low.
The inherent risk to the income stream of a hotel is, therefore, much greater. Yet, conversely, the income yield per square meter of usable space may be higher.
Lower risk properties command lower cap rates—and therefore higher “multipliers” on the net come to derive the capital value.
Typically, on a scale of risk, the following commercial properties may be ranked as follows;
Lower risk: say 4-5%
Prime street side retail space
Medium risk: say 6-7%
Lower grade office
Secondary retail and shopping centers
Higher risk: say 8-10%
When preparing an underwriting or pro-forma, selecting the most appropriate cap rate is a combination of using market evidence but also having the experience in knowing the risks attached to each type of commercial property.
In case of “mixed use” property (ie a property with multi-family units, retail space and offices in the same building or complex), each asset class can be ascribed an appropriate cap rate, and then the total of the derived capital values can then be divided by the total net income from all components of the property to produce an average or “blended” cap rate.
What Is A Good Cap Rate For Rental Property?
There is no strict definition of a “good cap rate” as each property will vary slightly. However, typically around 4-5% is considered to be acceptable. There is also a difference between a “good” cap rate and a “safe” cap rate, with the latter being an assessment by the investor of how much risk they are comfortable with.
How do cap rates work?
A cap rate can be based on either a gross or net yield basis. However, when based on a gross yield it has limited use as the amount of operating expenses are unknown.
Some basic examples to demonstrate how cap rates are calculated follow, and these exclude the effects property or other taxes:
An investor buys a small multi-family block with 6 units:
$800,000 each x 6 = $4,800,000
Total annual rental for 6 units = $ 240,000
Gross RoI = $ 240,000 divided by $4,800,000 = 5% or the gross cap rate
So, it is necessary to deduct all operating expenses and taxes to derive a Net RoI which will help give a more useful comparison between properties .
Let’s say, simplistically, that:
all expenses amount to 20% of the Gross NoI and this will reduce the NoI down to $ 192,000 per annum or a net cap rate of 4%.
As mentioned above, if the net (or gross) cap rate of 4% is already known then the current market value can be calculated by dividing the net income by the cap rate or:
$ 192,000/4% = $4,800,000
As before, if an investor buys a small multi-family block with 6 units as follows:
$800,000 each x 6 = $4,800,000
However, in this case, only $ 2,400,000 is invested as the remaining $ 2,400,000 is provided by a lender; therefore, the calculation of return can be based only upon the amount of money you invested (ie $ 2,400,000) called RoE
Annual rental for 6 units = $ 240,000
Gross RoI = $ 2,400,000 divided by $ 240,000 = 10% or the gross cap rate
Deduct all operating expenses and taxes to derive a Net RoI.
Let’s say, simplistically, that:
all expenses amount to 20% of the Gross NoI; this makes the NoI $ 192,000 per annum or RoE of 8%, double that if no loan was secured.
Using a known cap rate to help find the capital value of a property
If the unleveraged (net) cap rate of a property is known to be, say 4% then it’s possible to work out the current market value by dividing the net income by the cap rate or:
$ 192,000/4% = $4,800,000
At CPI Capital we understand the importance of using and comparing cap rates as an important tool to make a preliminary assessment of the return an investor can expect when investing in multi-family. Yet we are also experienced enough to know that other more sophisticated techniques such as a DCF or IRR analysis need to be used to supplement the initial analysis and present a detailed, underwriting proposal.
Clearly, as no two properties are exactly the same, the actual cap rate adopted will vary according to the risk profile of the income stream and also a variety of other factors.
A cap rate comparison used in REPE investment may sound simple, but it can save a lot of time, enabling investors to discard less attractive investments at an early stage, and standing a better chance of achieving success with other more attractive projects.
CSO, COO, Co-Founder CPI Capital