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# Cap Rate

Quick Primer on Understanding the Cap Rate in Real Estate (2023 Update)

• The cap rate is defined as the potential rate of return on a rental property building, such as a commercial real estate investment.
• The cap rate formula divides the net operating income (NOI) of a rental property at stabilization by the market value of the property as of the present date.
• The cap rate is frequently used among real estate practitioners to compare different investment opportunities to determine the property with the most attractive risk-return profile.
• The higher the cap rate, the higher the risk and potential return – all else being equal.
• There is no good cap rate, per se, because the decision is subjective and contingent on the specific investor’s risk-return profile, but most commercial real estate investors target a cap rate between 4% to 10%.

## What are Cap Rates in Real Estate?

The cap rate, an abbreviation for “capitalization rate,” is a real estate metric that reflects the expected rate of return on rental property investments.

The commercial real estate (CRE) market participants must closely weigh the risk-return profiles of potential investments to determine the purchase price at which the target yield is attainable to guide their investment decision-making process.

Cap rates are the primary shorthand by which different properties with comparable risk-return profiles can be analyzed side-by-side.

Cap rates in real estate estimate the rate of return on rental properties based on their perceived income potential.

The NOI of the properties must be expressed on a pro forma basis to reflect the income that the properties expect to generate at stabilization.

Stabilization refers to the state at which a real estate development project or acquisition is near complete, and the property is close to fully functional, with the rental units of the property leased near full occupancy with rent prices close to the market rate.

By converting the NOI of a property into a percentage, the cap rate is a standardized metric that facilitates “apples-to-apples” comparisons between comparable properties to identify the investment opportunities that offer attractive risk-return trade-offs.

## How to Calculate Cap Rate?

The cap rate is calculated by dividing the net operating income (NOI) of a rental investment property by the market value of the property as of the present date.

The net operating income (NOI) and property value are the two inputs in the cap rate formula:

1. Net Operating Income (NOI) → The net operating income, or “NOI,” represents the income potential of a property based on its core drivers of revenue, such as rent payments, minus its operating expenses, e.g., maintenance costs, property taxes, and insurance.
2. Property Value → The current market value, on the other hand, is the property’s fair market value (FMV) as of the present date. The fair value is determined in an independent appraisal and is intended to reflect the current value of the property rather than the original purchase price.

The NOI used to analyze the capitalization rate of rental properties must be stabilized to reflect their “steady-state” performance, wherein the operations of the properties are functional and starting to generate rental income.

The step-by-step process to calculate the cap rate is as follows.

1. Calculate the Net Operating Income (NOI) of the Property at Stabilization
2. Determine the Market Value of the Property as of the Present Date
3. Divide the Property’s Annual NOI by its Current Market Value
4. Multiply by 100 to Convert from Decimal Notation to Percentage Form

## Cap Rate Formula

The formula to calculate the cap rate is the net operating income (NOI) of the property divided by the present market value of the property.

Cap Rate (%) = Net Operating Income (NOI) ÷ Property Value

Where:

• Net Operating Income (NOI) → The NOI of a property investment equals the sum of the property’s rental income and ancillary income, net of any direct operating expenses incurred.
• Property Value → The property value refers to the current market value of the property as of the present date, i.e., the fair value of the property. Or, the property’s purchase cost can be used depending on the context of the analysis.

The formula to calculate the net operating income (NOI) is the sum of the rental and ancillary income, less direct operating expenses.

Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses

The NOI can also be computed by subtracting a property’s effective gross income (EGI) from its direct operating expenses.

• Net Operating Income (NOI) = Effective Gross Income (EGI) – Direct Operating Expenses
• Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses
• Potential Gross Income (PGI) = (Total Number of Units × Annual Market Rate Rent) + Other Income

## Does Cap Rate Include Mortgage Payments?

One of the more common questions regarding the capitalization rate received by students and trainees is, “Does the cap rate formula include mortgage payments?”

The answer? No, the cap rate calculation does not include mortgage payments or interest on real estate loans.

The rationale for the capitalization rate metric neglecting mortgage and interest payments is that those spending activities are categorized as financing costs rather than operating costs.

Cap rates are thus an unlevered measure of returns used to analyze individual investment properties and perform comps analysis.

• Financing Structure → The funding sources of the real estate project are at the discretion of the new investor post-closing, so the prior capitalization does not matter, for the most part.
• Unlevered Return Metric→ Since the effects of debt financing are neglected in net operating income (NOI) – unlike financial metrics such as net income – the cap rate is an “unlevered” measure of returns suited for comparability.

## NOI / Cap Rate Formula

Under the income approach, or “direct capitalization method,” the value of a real estate investment property is estimated by dividing the property’s net operating income (NOI) by its cap rate.

Property Value = Net Operating Income (NOI) ÷ Capitalization Rate

For example, if an investor owns a property generating \$3 million in annual net operating income (NOI), yet comparable properties trade at only 6.0% cap rates – perhaps because of more risks with these types of properties – the investor can use the capitalization rate derived from the peer group to guide the pricing analysis.

Given the 6.0% capitalization rate, the pricing of our property investment should be near \$50 million.

• Property Price = \$3 million ÷ 6.0% = \$50 million

Likewise, multiplying the NOI by the net operating income multiplier (\$50 million ÷ \$3 million) yields the same property value.

• Property Price = \$3 million × 16.7x = \$50 million

“Cap Rate is the Inverse of a Multiple”

## Commercial Rental Property Cap Rate Calculation Example

Suppose a commercial real estate investment firm performs diligence on a commercial rental property that generates \$1.2 million in net operating income (NOI).

The commercial real estate (CRE) rental property is currently available for purchase on the market, with the asking price set by the seller at \$10 million.

• Property Asking Price = \$10 million
• Net Operating Income (NOI) = \$1.2 million

Given the asking price of \$10 million and annual NOI of \$1.2 million, what is the implied cap rate?

The property asset value of the commercial real estate investment equals the property’s NOI divided by its current market value.

The formula can be rearranged to solve for the implied cap rate, which comes out to 12.0%.

• Property Value = Net Operating Income (NOI) ÷ Cap Rate (%)
• \$10 million = \$1.2 million ÷ Cap Rate (%)
• Cap Rate (%) = \$1.2 million ÷ \$10 million = 12.0%

If you’re more familiar with the EV/EBITDA multiple, the closest thing to a cap rate is an inverse EBITDA multiple.

Why? The net operating income (NOI) is a measure of profitability with numerous similarities to the EBITDA metric.

Therefore, if we multiply the commercial real estate (CRE) property’s NOI multiple by annual NOI, the implied value of the property comes out as \$10 million like before.

• NOI Multiple = \$10 million ÷ \$1.2 million = 8.3x
• Property Value = 8.3x × \$1.2 million = \$10 million

The annual return is \$1.2 million, so the number of years for the investment to reach its breakeven point is estimated to be around 8.3 years.

• Annual Return = 12.0% ÷ \$10 million = \$1.2 million
• Number of Years to Breakeven = \$10 million ÷ \$1.2 million = ~8.3 Years

## What is a Good Cap Rate?

Understanding the core determinants of a property’s cap rate is necessary to analyze changes over time and interpret data correctly.

So, what are the underlying factors that can cause the cap rates of rental properties to increase or decrease?

• High Cap Rates → If capitalization rates increase, property prices might be falling (or stagnating). Otherwise, the potential cause could be rent is rising at a faster pace than property values. High cap rates generally imply higher risk and, thus, higher potential returns.
• Low Cap Rates → On the other hand, property prices rise faster than rents if capitalization rates are falling. Low cap rates tend to suggest the investment is less risky, which coincides with lower returns.

That said, the higher the cap rate, the higher the annual return on investment (ROI) – all else being equal.

Generally speaking, a “good” cap rate ranges between 4% and 10%, but the target return is contingent on the property type, location, and current market conditions.

The target cap rate is specific to the real estate property investor and is subjective for the most part, so there is no industry standard for the minimum “hurdle rate” to invest.

## Why is a Higher Cap Rate Riskier?

The cap rate is a measure of returns, so the metric is also a measure of risk since risk and return are two sides of the same coin.

So, is it better to have a high or low cap rate?

In short, the answer is rather nuanced and entirely dependent on the investor (and surrounding circumstances).

Contrary to a common misconception, a higher cap rate is not always better nor preferred by real estate investors.

The reason? Higher cap rates are often achieved by investing in riskier properties, so a trade-off between risk and return must be understood.

A higher capitalization rate implies more risk attributable to a real estate property investment (and vice versa for a lower capitalization rate). That said, a real estate investment firm’s priorities ultimately determine its target capitalization rate:

• Yield vs. Capital Preservation → Certain real estate investors prioritize capital preservation – i.e., minimizing the risk of capital loss on an investment – whereas others are more yield-oriented and set a higher bar for the required rate of return.
• Risk Appetite → The risk tolerance varies by the investor, which goes hand-in-hand with the prior factor since more risk should correspond with higher returns to compensate the investor for undertaking the incremental risk (and vice versa).

For instance, a risk-averse real estate investor pursuing a long-term, steady stream of income is likely to prefer properties with lower capitalization rates located in stable markets instead of riskier properties with higher cap rates.

## What Does a 7.5% Cap Rate Mean?

For example, suppose a \$2 million real estate property is expected to generate \$150,000 in annual net operating income (NOI) at stabilization.

• Property Value = \$2 million
• Net Operating Income (NOI) = \$150,000

Given the NOI and property value assumptions, we can input those figures into our capitalization rate equation, resulting in an implied capitalization rate of 7.5%.

• Capitalization Rate (%) = \$150,000 ÷ \$2 million = 7.5%

So, what does the 7.5% cap rate mean?

The 7.5% cap rate means that an investor should expect to earn a 7.5% annual return on the investment property or an annual return of \$150,000 in dollar figures.

• Annual Return @ 7.5% Cap Rate = 7.5% × \$2 million = \$150k

Given the annual return of \$150k, the investor should expect to recoup the initial contribution in approximately 13 years, i.e., the time required for the investment to reach the breakeven point, where the property starts to pay for itself (Cumulative Return = Purchase Cost)

•  Number of Years to Breakeven = \$2 million ÷ \$150k = 13.3 Years

## Cap Rate Compression vs. Expansion: What is the Difference?

If the cap rates in a particular real estate market decline, the market is said to be in a state of “cap rate compression.”

Conversely, if the cap rates rise instead, the market is undergoing “cap rate expansion.”

The cap rates on rental properties and the property values are inversely related.

• Cap Rate Compression → Increase in Property Values (or Rise in Purchase Prices)
• Cap Rate Expansion → Decrease in Property Values (or Reduction in Purchase Prices)

As a general rule of thumb, a market exhibiting cap rate compression should be expected to observe rising property asset values – all else being equal.

However, contrary to a frequent misconception, lower cap rates do not simply mean less risk in a potential investment.

While the statement can be true in certain scenarios, there are exceptions in which the cap rates decline following a widespread increase in property asset values.

Inflated property valuations in irrational markets often coincide with market factors that contribute to lower returns earned by real estate investors.

• Higher Purchase Price → A real estate market with high property valuations is characterized by higher purchase prices by new investors (i.e., higher risk of overpaying for the asset)
• Market Competition → Competition among buyers and investors tends to cause property valuations to rise, often to an unreasonable level (i.e., seller’s market) – all else being equal. Therefore, the purchase price paid by the investor or buyer likely contains a significant purchase premium, referred to as the “winner’s curse” in M&A.
• Market Cyclicality → Often, investing at the “peak” in a cyclical market or attempting to profit from short-term trends can cause real estate investors to incur significant losses.

The preferred scenario, in which cap rate compression is unfavorable to investors, stems from a rise in property values without a proportionate increase in net operating income (NOI).

But if the net operating income (NOI) of the properties in the market either increases at a comparable pace (or perhaps even outpace) the recent rise observed in property values, the investment opportunities here could be worthwhile to pursue.

## Cap Rate vs. Yield: What is the Difference?

The cap rate and yield measures annual returns in real estate investing. However, the differences in the return metrics stem from the denominator of the formula.

• Cap Rate → The cap rate calculation uses the property value in the denominator. Therefore, the cap rate fluctuates based on the current market value of a property. The value of properties and cap rates have an inverse relationship, where property values rise as cap rates fall (and vice versa).
• Yield → On the other hand, the calculation of the yield metric utilizes the property cost (or purchase price). Unlike the property value, the property cost remains static and unchanged, irrespective of changes in the market conditions that impact the valuation of properties. On the original purchase date, the variance between the cap rate and yield is usually marginal, barring unusual circumstances. However, the property’s market value is not fixed, so the two can drift apart as the real estate market undergoes different phases in its cycle.

The yield on an investment property can be expressed on an unlevered or levered basis.

Unlevered Yield (%) = Net Operating Income (NOI) ÷ Purchase Price
Levered Yield = Cash Flow After Debt Service (CFADS) ÷ Equity Contribution

The distinction between the cap rate and yield remains in either case, as the denominator is a constant figure, i.e., the purchase price and equity contribution (down payment) are unaffected by the current state of the market.

However, the cap rate can be an influential factor in the yield on rental investments because of its influence on property asset values (and purchase prices).

If cap rates in the market fall and property purchase prices rise, the yield tends to fall, which is attributable to the cost of purchasing the property becoming more expensive.

## Cap Rate vs. Cash on Cash Return: What is the Difference?

The difference between the cap rate and cash-on-cash return is as follows.

• Cap Rate → The capitalization rate, as mentioned earlier, measures the rate of return expected on a rental property investment. Contrary to the cash-on-cash return, the capitalization rate neglects the effects of financing (i.e., capital structure neutral) since the numerator is the net operating income (NOI). NOI is an unlevered profit metric not impacted by discretionary financing decisions, contrary to a metric such as net income. Hence, the capitalization rate excludes financing costs such as mortgage payments, unlike the cash-on-cash return.
• Cash on Cash Return → The cash on cash return, or “cash yield,” measures the annual pre-tax cash flow received per dollar of equity invested. Unlike the cap rate, the cash-on-cash return is a levered metric determined post-financing because the numerator is the annual pre-tax cash flow. The levered pre-tax cash flow metric is unaffected by taxes but is reduced by the annual debt service, which includes mortgage payments and periodic interest payments.

The formula to calculate the cash-on-cash return consists of dividing a property’s annual levered pre-tax cash flow by the equity contribution from the real estate investor’s perspective.

Cash on Cash Return (%) = Annual Pre-Tax Cash Flow ÷ Equity Contribution

## How Do Interest Rates Affect Cap Rates?

The interest rate environment is an influential factor in property valuations, namely because interest rates reflect the cost of borrowing. Therefore, understanding the relationship between interest rates and cap rates is critical for investors.

• Rising Interest Rates → If interest rates rise, the cost of borrowing increases in tandem, effectively reducing the purchasing power of market participants and the affordability of properties. The rise in borrowing costs amid periods of high-interest rates in the economy is representative of unfavorable conditions to investors, as their access to obtain the necessary financing to fund property acquisitions becomes restricted.
• Declining Interest Rates → If interest rates fall, the cost of borrowing declines, meaning there is more “cheap” capital readily available, which increases the purchasing power of property investors and causes demand in the market to spike since properties are now more affordable.

Because real estate investors face more risk in high-interest rate periods, most demand a higher rate of return on their investment to compensate for the incremental cost of borrowing.

Given the reduction in demand from buyers in the market and increased competition among sellers, the asking price of properties tends to decrease (and sellers offer more incentives to attract interest from buyers).

Why? Since higher interest rates tend to hinder demand in the market from prospective buyers and investors, sellers must offset the higher cost of financing by reducing the sale prices of their properties to expand the pool of potential buyers.

From the perspective of property investors, a lower purchase price increases their potential returns and makes reaching the minimum yield easier – all else being equal.

But while there certainly appears to be historical market data implying a correlation between interest rates and property prices, there are other factors that can impact pricing, such as the following:

• Economic Conditions
• Credit Markets
• Employment and Wages (and Unemployment Rate)
• GDP Growth Rate
• Inflation Growth Rate (CPI)
• Rent Price Growth
• NOI Growth

U.S. Cap Rate Survey H1 2023 (Source: CBRE)

## Cap Rate Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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## 1. Commercial Real Estate Investment Property Assumptions

Suppose a commercial real estate investment firm (CRE) is analyzing a potential rental property investment opportunity with a current property value of \$75 million.

The pro forma financial data of the commercial real estate investment – the strategic acquisition of an office building – for the fiscal year ending 2023 is as follows.

Commercial Real Estate Investment (CRE) – Office Building

• Potential Gross Income (PGI) = \$10.2 million
• Vacancy and Credit Losses = \$200k
• Property Management Fees = \$1,000k
• Maintenance and Repairs = \$500k
• Property Taxes = \$800k
• Property Insurance = \$600k

## 2. NOI Calculation Example

The commercial real estate (CRE) investment firm decides a good starting point is to calculate the property’s cap rate, in which the first step is to compute the property’s effective gross income (EGI).

The difference between the potential gross income (PGI) and vacancy & credit losses is the commercial property’s effective gross income (EGI), which amounts to \$10 million.

• Effective Gross Income (EGI) = \$10.2 million – \$200k = \$10 million

In the next step, we’ll deduct the commercial real estate property’s operating expenses to arrive at net operating income (NOI).

• Net Operating Income (NOI) = \$10 million – \$1 million – \$500k – \$800k – \$600k = \$7.1 million

Therefore, the commercial office building is expected to generate \$7.1 million in net operating income (NOI) at stabilization.

## 3. Cap Rate Calculation Example

Since the property value was provided as an assumption earlier, whereas the NOI was just calculated in the prior section, the required formula inputs to compute the capitalization rate are set.

• Net Operating Income (NOI) = \$7.1 million
• Property Value = \$75 million

By dividing the commercial real estate property’s net operating income (NOI) by the current property value, we arrive at an implied cap rate of 9.5%.

• Cap Rate (%) = \$7.1 million ÷ \$75 million = 9.5%

## 4. Cap Rate and NOI Property Appraisal Example

In the final part of our modeling exercise in Excel, we’ll conclude by solving for the estimated property value of the commercial real estate (CRE) property using the direct capitalization method.

The property value of the commercial real estate (CRE) office building was stated as an assumption earlier, but we can neglect that, for now, to better illustrate the relationship between NOI and capitalization rate.

The annual NOI that we computed is \$7.1 million, while the capitalization rate was 9.5% (or, more specifically, 9.467%).

Upon dividing our property’s net operating income (NOI) by its cap rate, we arrive at an implied property value of \$75 million, which matches the original assumption stated at the start of our tutorial.

• Implied Property Value = \$7.1 million ÷ 9.467% = \$75 million

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