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Breaking Down the Most Important Metric in Real Estate
Online Course: Everything you need to build and interpret real estate finance models.
The capitalization rate (cap rate), along with net operating income are the most important metrics in real estate. Together, they are used to value real estate properties.
The cap rate measures the a real estate property’s operating profit as a % of the property’s value. If you’re familiar with valuation multiples, you may have noticed that it’s simply an inverse of a multiple.
Cap Rate Example
A property with asking price of $1m and NOI of $125k will have a $125k / $1 m = 12.5% cap rate.
If you’re specifically familiar with EV/ EBITDA multiples, the closest thing to a cap rate is is an inverse EBITDA multiple because NOI as a measure of profit is closest to EBITDA (with some major differences which we address here).
Cap rates are the primary shorthand by which different real estate properties are compared by investors. For example, if you’re evaluating a property with a $10 million asking price and expected NOI of $1 million, that property would have a 10% cap rate.
Observed property value – To decide whether the asking price is appropriate, you’d look at the cap rates on similar properties. If the cap rates of comparable properties are on average lower – say 8% – you might perceive the asking price as reasonable because it provides a higher NOI relative to the property value.
If you’re more comfortable thinking about multiples, simply invert the cap rate – in our example you’d be comparing an asset valued at 10x (value/NOI) against a seemingly more expensive peer group trading at 12.5x (value/NOI).
Defined cap rate – Alternatively, cap rates are often used to help price properties. For example, if an investor own a property generating NOI of $2 million but comparable properties trade at only 6% cap rates (perhaps due to higher risks with these types of properties), the investor would use the peer group cap rates to guide the investor’s pricing decision. So at the 6% cap rate, the property would be priced at $2 million / 6% = $33.3 million.
Just as with traditional multiples, there are many variables that can distort the comparison of properties using this metric, including:
However, in real estate, it is much easier to find comparable properties (with therefore similar growth, returns and cost of capital profiles), which mutes the problems described above
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