**Cap Rate Definition**

What is a cap rate? The capitalization rate, often just called the cap rate, is the ratio of Net Operating Income (NOI) to property asset value. As an example, if a property recently sold for $1,000,000 and had an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.

**Cap Rate Example**

Using this example we discover that a recent sale of an office building with a Net Operating Income (NOI) of $1,000,000, and a sale price of $17,000,000. Therefore this property sold at a 5.8% cap rate.

**Thoughts behind the Cap Rate**

What is the cap rate telling you? One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase. In the above example, assuming the real estate proforma is accurate, an all-cash investment of $17,000,000 would produce an annual return on investment of 5.8%. Another way to think about the cap rate is that it’s just the 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 a Good Cap Rate?**

What’s a good cap rate? The short answer is that it depends on how you are using the cap rate. For example, if you are selling a property then a lower cap rate is good because it means the value of your property will be higher. On the other hand, if you are buying a property then a higher cap rate is good because it means your initial investment will be lower.

You might also be trying to find a market-based cap rate using recent sales of comparable properties. 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.

**When, and When Not, to Use a Cap Rate**

The cap rate is a very common and useful ratio in the commercial real estate industry and it can be helpful in several scenarios. For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.

Another way 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 creditworthiness 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 Real Estate Broker

broker@allenmayer.ca