Cap Rate Primer

What is a Good Cap Rate?

The ideal cap rate is widely accepted as between 5% and 10% in the commercial real estate (CRE) market.

But of course, there are a broad number of factors, such as property type, classification, and asset class, that influence what a “good” cap rate is.

The primary reason interest rates matter is because the cost of borrowing (or debt) is affected.

The less equity required to be contributed to fund the property purchase price by the real estate investor, the higher the upside potential on the investment (and vice versa).

• Declining Interest Rate ➝ If the interest rates in the credit markets are reducing, real estate investors have more access to “cheap” capital with favorable borrowing terms (i.e. more buyer power and funds to finance CRE projects)
• Rising Interest Rate ➝ If interest rates are rising, the cost of capital is higher, so loans are priced at less favorable terms, reducing the expected return on a property investment.

Is a Higher Cap Rate Better?

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.

In short, the answer is rather nuanced and subject to the specific investment strategy, minimum required rate of return, and risk tolerance specific to the investor.

However, the notion that all real estate investors prefer a higher cap rate is misinformed.

Why? Certain real estate investors prioritize capital preservation—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.

• Higher Cap Rate ➝ Real estate properties with higher cap rates are perceived as riskier investments with less stability in their cash flow. However, the increased riskiness of the cash flows can be appealing to certain yield-oriented commercial real estate (CRE) investors, as the potential upside is greater.
• Lower Cap Rate ➝ On the other hand, real estate properties with lower capitalization rates are viewed as more conservative investments that generate stable income. Thus, risk-averse commercial real estate (CRE) investors are likely to find properties with steady income and situated in low-growth markets to be more attractive.

The trade-off here is that the predictability of the property’s NOI reduces the potential to earn an outsized yield above the original projection, barring unforeseen circumstances.

The risk tolerance varies by the specific investor, which goes hand-in-hand with the prior factor, as undertaking incremental risk must be compensated with a higher return.

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

The difference between the cap rate and cash yield is as follows:

• Cap Rate ➝ The cap rate is the return expected on a rental property investment. Unlike the cash yield, the cap rate neglects the effects of financing (i.e. capital structure neutral) since the numerator is net operating income (NOI), an unlevered profitability metric unaffected by discretionary financing decisions. Therefore, the cap rate excludes financing costs such as interest and mortgage payments.
• Cash Yield ➝ The cash yield, or “cash on cash return,” is the annual pre-tax levered cash flow received per dollar of equity invested. In contrast to the cap rate, the cash yield is a levered metric (post-financing) because the debt service reduces the annual pre-tax cash flow.

The formula to calculate the cash yield consists of dividing the levered cash flow of a property by the equity investment contributed by the real estate investor.

Where:

• Levered Cash Flow = Net Operating Income (NOI) – Annual Debt Service
• Equity Contribution = Purchase Price – Total Debt

The levered cash flow is the rental income a property generates after deducting the annual debt service but before income taxes. The equity contribution is the cash investment (or “down payment”) the investor needs to close the real estate transaction.

The cap rate is a pro-forma measure of the implied return on an investment property as of the date of acquisition. In contrast, the constant denominator in the cash yield remains indifferent to the current state of the real estate market conditions, considering fixed purchase price and equity contribution.

The cash yield can determine the return earned on an equity investment on a rolling basis, where the percentage return fluctuates over time in tandem with the cash flow generated.

Since net operating income (NOI) neglects the effects of debt financing, the cap rate is better suited for comparative analysis, unlike the cash-on-cash return.

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

The cyclically is an influential factor that directly impacts the property valuation of real estate assets in the broader market.

Based on the perceived risk, the investment strategies among buyers often pivot in response, wherein adjustments are applied per emerging market trends.

The investor sentiment at present is a continuously fluctuating external factor that affects market demand, with the potential to cause cap rates to rise or decline.

With that said, cap rate expansion coincides with falling property values, while cap rate compression implies rising property values.

• Cap Rate Expansion ➝ Cap rate expansion refers to market conditions where the potential return and risk on property investments are higher.
• Cap Rate Compression ➝ Conversely, cap rate compression occurs when the implied return (and risk) declines in the market, causing cap rates to reduce.

Cap Rate Calculator — Excel Template

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 Rental Property Investment Assumptions

Suppose a commercial real estate (CRE) investment firm is analyzing a potential rental property investment opportunity with a current property value of $84 million.

• Property Value = $84 million

The pro-forma metrics for the commercial rental property investment—the strategic acquisition of an office building in NYC—at stabilization (Year 1) are as follows:

• Potential Gross Income (PGI) = $16 million
• Vacancy and Credit Losses = ($800k)
• Property Taxes = ($4 million)
• Property Management Fees = ($2.5 million)
• Property Insurance = ($2 million)
• Maintenance and Repairs = ($1.2 million)
• Other Direct Operating Expenses = ($500k)

2. Stabilized NOI Calculation

The effective gross income (EGI) of the property must be estimated as the first step toward determining the cap rate.

The $10 million difference between potential gross income (PGI) and vacancy and credit losses is the commercial rental property’s effective gross income (EGI).

• Effective Gross Income (EGI) = $16 million – $200k = $10 million

In the next step, we’ll deduct the operating expenses of the commercial real estate property to arrive at the property’s net operating income (NOI), which is $7.1 million.

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

3. Real Estate Pro Forma Forecast

In our pro-forma forecast model, the property’s NOI at stabilization is estimated by subtracting direct operating expenses from effective gross income (EGI).

Where:

• Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses

The consolidated pro-forma financial data for the commercial real estate (CRE) property investment are inserted into the following table to arrive at a net operating income (NOI) of $5 million.

4. Cap Rate Calculation Example

Since the property value was stated as an assumption earlier, whereas the NOI was calculated in the prior section, the required formula inputs to compute the implied cap rate are stated here:

• Net Operating Income (NOI) = $5 million
• Property Value = $84 million

By dividing the commercial real estate property’s net operating income (NOI) by the current property value, we arrive at a pro-forma cap rate of 6.0%.

• Pro-Forma Cap Rate (%) = $5 million ÷ $84 million = 6.0%

5. Income Approach Appraisal (NOI / Cap Rate)

In the next section, we’ll solve the estimated property value of the commercial real estate (CRE) property under the direct capitalization method.

The property value of the commercial office building was stated as an assumption earlier. Still, we can deliberately neglect that for the sake of illustrating the relationship between NOI and cap rate.

The stabilized NOI of the rental property is projected to be $5 million, while the capitalization rate is 6%.

Upon dividing our property’s net operating income (NOI) by the cap rate, we arrive at an implied property value of $84 million, which matches the original assumption stated at the start of our tutorial.

• Implied Property Value = $5 million million ÷ 6.0% = $84 million

6. Cap Rate Sensitivity Analysis Matrix

In the final part of our modeling exercise, we’ll complete the analysis of our hypothetical rental property investment by performing a sensitivity analysis (or “what-if” analysis).

The two variables selected in our sensitivity analysis matrix are net operating income (NOI) and purchase price, placed on the X-axis and Y-axis, respectively.

Our sensitivity matrix illustrates the relationship between net operating income (NOI) and purchase price, where a higher NOI and lower purchase price yield a higher cap rate (and vice versa).

• Higher NOI + Lower Purchase Price ➝ Higher Cap Rate
• Lower NOI + Higher Purchase Price ➝ Lower Cap Rate