It is rare to have a conversation about investment real estate without the term “cap rate” being mentioned. Cap rate is short for capitalization rate and represents the relationship between a property’s value and its income. It is a snapshot of the property’s performance in the year of the purchase, however, it may not be representative of the property’s future performance. Looking at a cap rate in the initial year of the purchase is similar to looking at the yield on a treasury bond. Simply put, a cap rate is the percentage return an investor would get on their money if they bought real estate and paid cash for it. It is an easy way to compare one property’s return to another property’s, even if the price, location, and type of properties being compared vary greatly. To determine a cap rate, one takes the net operating income (NOI) and divides it by the purchase price. If you have a property that nets $75,000 per year in income and the purchase price is $1,000,000, the cap rate would be 7.5% ($75,000/$1,000,000=.075).
There are many different ways of evaluating properties. Some can be very time-consuming such as developing a 10-year projected cash flow with varying expenses and income based on things like improvements made to the building and projected market shifts. Cap rates are relatively simple and can be useful when evaluating multiple properties without needing to do an in-depth analysis for each property. However, NOI needs to be vetted to make sure the data being used is accurate and representative of future potential income. The stabilized income for a property may be very different than the income reported on tax returns. For example, if we look at 2020 income on a property there is a good chance that rents were not paid in full because of the pandemic and income may have been lower than future years will be. Conversely, the owner may have received grants or incentives that were offered during the pandemic and had lower expenses than usual due to decreased occupancy. This would increase the NOI and be an anomaly that is not representative of future income. To evaluate cap rates successfully, one must use stabilized income and expenses. One would also make adjustments to add back depreciation expenses and interest expenses and make sure there was a management expense commensurate with the amount of time it takes to manage the property.
Investors often ask “what should the cap rate be?” This changes over time and depends on alternative investments. With 10-year Treasury bonds yielding just over 1%, investors may be happy with a 4-5% return on their real estate. The biggest factor in the decision of an acceptable cap rate is going to be the amount of risk. With a long-term lease on a credit-rated tenant, 4-5% may be an acceptable level of risk. If there are multiple tenants and short-term leases, the risk of vacancy is higher and the investor may demand a higher return on their money, thus desiring an 8-10% cap rate. Cap rate compression means cap rates are decreasing and prices are increasing. This is what we have seen due to decreasing rates of return on alternative investments in recent years. Capitalization rates are also influenced by many other factors such as supply and demand for space. Demand for investment real estate has been extremely high lately. When demand outstrips the supply of available spaces, prices increase and cap rates are pushed lower. The risk of inflation puts downward pressure on cap rates since investors view real estate as a hedge against inflation (rents will rise increasing NOI if there is inflation). Another important factor is the availability of money to borrow to buy a property. If it is easily available, such as the current situation, it contributes to cap rate compression. We also see different cap rates in different classes of assets. Current trends show the need for warehouse space increasing and office space decreasing. In this situation, we would expect to see lower cap rates for warehouse space than office space. The belief is that warehousing may command higher rents in the future and office rent may decrease or increase more slowly than warehouse space.
Cap rates can be a useful tool in evaluating a property as long as the data used is accurate. Determining a stabilized income using projected income and expenses may be more beneficial, although that also introduces subjectivity to what is normally a straightforward process of defining value. Investors must determine if the income stated includes all of the expenses and an accurate vacancy rate. If a building has deferred maintenance and will need capital improvements, these costs should be factored in as well. There may be a lease that is higher than the market rate or is expiring soon and a new tenant will need to be obtained. There may be excess land that increases the value but does not factor into the cap rate analysis. It is important to understand all of the factors before deciding if a building is a good value based on the cap rate. However, with a good advisor and accurate financial projections, cap rates are a good investment analysis tool and helpful when deciding where to invest.