In real estate, one of the hardest aspects of investing is determining which property will be the best investment compared to others on the market. Since factors such as tax brackets or debt service will affect each buyer differently, how can an investor decide if an investment is a good one independent of a buyer’s specific conditions? That’s where capitalization rates (“cap rates”) come in. Generally, a cap rate measures the investment’s value independent of the buyer. Regardless of who is evaluating the property, the cap rate will remain the same. This allows investors to do an apples-to-apples comparison. In this insight, we will explain what cap rates really are and how they affect investors. When interest rates are expected to rise and as investors require higher yields to keep up with interest rates, cap rates will also increase. This increase will negatively affect sellers because valuations will decrease unless property owners can increase the property’s cash flow to keep up with the higher yields required by potential buyers.
When trying to decide whether a real estate investment is a good deal, what questions should an investor ask? For many investors, one of the first questions is, “So what cash flow does the property generate?” The answer to that question depends on each individual buyer’s circumstances. That’s why cash flow may not be a good metric to value an investment. For example, one investor might have a higher interest rate on his loan. Because of the higher interest rate, this investor’s payments increase which could result in a negative cash flow. Another investor may have a lower interest rate resulting in lower payments. This other investor may therefore be able to generate positive cash flow. Other factors, such as loan amortization or tax brackets, will also affect owners differently. That is why “cash-on-cash return” or “total return” may likewise present ambiguous indicators of a property’s value.
That is why real estate professionals use cap rates. The purpose of cap rates is to create a measure that can be used to compare properties on a level playing field independent of a buyer’s situation. In order to mitigate debt related issues, when using cap rates, it is assumed that the property is an all cash purchase.
A cap rate has two main components: (1) net operating income (“NOI”); and (2) the estimated value of the property. Since there is assumed to be no debt on the property, NOI is equivalent to cash flow before debt service. NOI is the amount of money the investor retains after collecting all the revenue and paying out all operating expenses. The cap rate is calculated by dividing the NOI by the property’s value.
Net Operating Income = Cap Rate
For example, an apartment building that has $60,000 of annual NOI and was purchased for $1,000,000 has a cap rate of 6.0%, calculated as follow:
$60,000 = 6.0%
Cap rates are used to determine value. Appraisers or commercial real estate brokers look at cap rates when establishing the fair market value of a property. The valuation formula is quite simple – NOI divided by the cap rate equals the fair market value. Using the numbers from above, a $60,000 NOI at a 6% cap rate would result in a value of $1,000,000:
$60,000 = $1,000,000
Cap rates are influenced by many factors such as the health of the economy, interest rates, interest rate expectations, vacancy rates, property type (industrial vs. multi-family), geographical area (New York vs. Los Angeles), or property class in the same city (Class A vs. Class B). As the cap rate changes, so does the value. For example, as a cap rate moves from 6% to 8% the value of a property decreases by 25% as reflected below
$60,000 = $750,000
Many investors do not distinguish a property by location or the class of property, but by its cap rate. A cap rate is another way to state the required yield of a potential buyer. Some buyers are looking for properties that have a cap rate of 7%, while others will only buy properties with a cap rate of higher than 10%. It depends on their objective. It is important to understand that as a general rule, the higher the cap rate (projected yield), the higher the risk.
In general, cap rates work similar to yields on bonds and/or price to earnings ratios with stocks; the lower the cap rate the safer the investment. A cap rate of 5% may have low vacancy, beautiful landscaping, good management, up-to-date amenities, rents at market rate, and strong cash flow each month. A buyer of this property is most interested in safety and predictability. Popular buyers of these properties are REITs.
As the cap rate increases, so does the risk. A property with a 10% cap rate might be in a less desirable part of town, have higher vacancies, or have older amenities. Buyers of these properties are willing to take additional risk and are looking to not only generate a higher yield but also increase the intrinsic value of the property by lowering the cap rate. As they are able to stabilize the vacancies, beautify the property, upgrade the amenities, enhance the management, etc. the risk to a new buyer is lessened, and hence the cap rate is reduced. As that happens, the value of the property increases. For example, if a buyer purchases at a 10% cap rate, but can sell at an 8% cap rate, he can generate a profit of 25%.
$60,000 NOI = $600,000 Property Value
10.0% Cap Rate
$60,000 NOI = $750,000 Property Value
8.0% Cap Rate
Almost all experts are in agreement that the low interest rates of today cannot last forever. With threats of inflation being seen in many areas, and the Federal Reserve still printing money at an alarming rate, it is almost certain that interest rates will start to move up. As interest rates move higher, the costs of borrowing increase, which also means the yield that investors require will increase. This will put upward pressure on cap rates, which, as explained above, will decrease property values.
Even if you believe (as we do) that interest rates will move higher, it does not necessarily mean this is a bad time to invest in real estate. There are four primary reasons why we think now is a good time to buy real estate. First, money is cheap. The cost of capital for real estate investors is low—especially for income producing real estate. Second, the recent and current financial recession and real estate collapse have created several dislocations in the real estate market. These dislocations created opportunities that were not previously available to buy cheap from distressed sellers. Distressed sellers are willing to sell properties at cap rates much higher than prevailing rates. Third, many properties have been neglected and mismanaged which allows a buyer to purchase at a high cap rate. If failing operations can be stabilized, then operational risk has been reduced and the cap rate can be driven down, thereby increasing the property value. Last but not least, inflation will eventually lead to higher lease rates, resulting in much higher values. This last point is particularly noteworthy as it relates to cap rates. For every dollar of increased operating income, a property’s value is increased by a multiple of the cap rate. For example, if net income can be increased by $1,000, the value of a property that sells at an 8% cap rate would be increased by $12,500.
Increase in Operating Income:
$1,000 increase in NOI = $12,500 increase in value
8.0% Cap Rate
As evidenced by the discussion above, an intimate understanding of cap rates and how they affect real estate values is critical when buying or selling real estate investments. If you have any questions please do not hesitate to give us a call.