Understanding how cap rates work is critical to evaluating real estate investments and the strategies that guide them. It’s not enough to just know that buying a high cap rate asset should produce more cash flow than a lower cap rate, which isn’t necessarily true. It’s also not necessarily true that a low cap rate means that a property is simply expensive and visa-versa. A cap rate goes far beyond telling you what the price of an asset may be or it’s unlevered return. Capitalization rates are an essential metric for any real estate investor as it acts as a tool for multiple purposes. A cap rate it can tell you the appreciation velocity of changes to NOIs , they give insight into the level of risk, liquidity, and market sentiment of a particular investment.
Usually, when learning a new concept or definition, actually using the term provides additional clarity when a definition gets too confusing. When learning about cap rates, arguably the reverse is true.
The market capitalization rate, or “cap rate,” of a commercial real estate investment property is easy to define: It is the Net Operating Income (NOI) divided by the property’s market value. In other words, how much money an asset brings in each year divided by how much the asset itself is worth. Cash flow before debt service and capital expenditures divided by value. Easy!
The reason why this blog post is titled “How Do Cap Rates Work” is because if it were titled “What Are Cap Rates,” there would not be very much to say after the above paragraph and formulas. The ways that cap rates work—how they change based on different factors, what to look for as a buyer/seller/investor, and when they may not be relevant—touch upon many key elements of real estate valuation that are crucial to successful investment. Among many other factors, location, appreciation, and the differing roles of buyer and seller all bring different ways of viewing cap rates.
Let’s begin with the perspective of an investor looking for a property to buy.
Costs and Appreciation
A building comes on the market, it’s valued at $10 million, and it has a cap rate of 10%. That’s not bad, right? $1,000,000 is a nice revenue stream, and this seems like a great deal. That 10%, however, is inseparably linked to the value of the property. The denominator in this formula, the market value, has a determining value on cap rates. Market values can change, thus, cap rates can change. A cap rate is a helpful tool, but it is not a promise.
Understanding how cap rates work as a part of different contexts can significantly improve your ability to find and shape high quality deals.
If, for example, you were interested in value-add projects and improvements on this $10 million building, that high cap rate could be read as a limiting factor. So, if your project leads to a $100/m rent increase on a 200 unit building, that is a $20,000 monthly increase, adding $240,000 to the properties NOI. If the market cap rate for that property is 5%, that’s an increase of value of $4,800,000. However, if the market cap rate for the property is 10%, that’s a value increase of only $2,400,000. In this situation, a lower cap rate means that rent increases have a more powerful effect on the forced appreciation of the property.
Conversely, cap rates take on a different role in predicting the impact of unexpected expenses and/or increases in costs. If there is a drop in NOI due to an increase of expenses or lower occupancy, the value is directly effected. Let’s say your turnover costs are $10,000 over the yearly budget. That $10K at a 5% cap is a drop of $200,000 in value. Ouch.
You may have heard that multifamily is a nickel and dimes business. It’s true. Every 10 cents of increased or decreased NOI at a 5% cap rate equates to $2 of increased or lost value.
The fundamental question a real estate investor must ask themselves is how they will balance their preference of cash flow and appreciation. Higher cap rate can provide immediate higher cash on cash, but less chance of appreciation unless you reposition the asset to be traded at a lower cap rate that is typically limited by your market. Lower cap rate assets may provide minimal cash on cash but slight increases to NOI can accelerate value much faster.
Everybody likes high returns, no one likes risk. Cap rates help to show the relationship between risk and return. Investments with low risk attract the more investors which drives prices up and returns down. As one travels up the risk spectrum, there are fewer buyers and therefore higher prices. Navigating risk is key to driving higher returns. a 10% cap rate might seem attractive due to the anticipated higher cash flow, but those higher returns typically also go along with a higher degree of standard deviation, or statistical change. This could be due to several reasons from liquidity of the particular asset type in a market, the market may be more volatile, or the property could be in a rough neighborhood and might require extensive management. A lower cap rate, on the other hand, may indicate a higher degree of liquidity and interest, or higher quality asset.
The statistical upside of taking risk is measured by the metric of risk premium. Risk premium is simply the return of an investment in excess of a “risk free rate,” typically benchmarked at the US 10 Year Treasury bond. If a prospective investment has a lower risk premium compared to investments with the same perceived level of risk then it might not be a great deal.
Risk Premium=10 Year Treasury – Investment Return
By understanding your market, having a business plan built on level fundamentals and the ability and experience to execute can lead to a quantification of risk involved in a particular asset. What one investor may determine risky may simply be out of a lack of information or means to execute a specific strategy. Real estate is historically a relative inefficient market, that leads to an opportunity for an investor driven by data, knowlege and experience.
Cap Rate and Debt Arbitrage
Cap rates vary depending on different markets, and finding an accurate cap rate for a specific market is crucial to assessing the value of a deal.
An example of navigating risk and using cap rates to ones advantage is by identifying inefficiencies in specific markets and using the more efficient debt markets to finance the asset. The majority of real estate investing is conducted by large institutions, including private equity firms, hedge funds, REITs, pension funds, sovereign wealth funds and family offices. These large investors deploy billions of dollars each year and primarily focus on “Gateway Markets” sometimes referred to “Tier 1” markets such as New York City, San Fransisco, Boston, and Los Angeles. Many have specific mandates that they only invest in those large markets. The result is high liquidity, higher prices, and lower cap rates. Knowing which markets tend to have higher cap rates, then, can sharpen your focus on the locations and properties with the most favorable risk and return.
The high level of liquidity in Gateway Markets does not mean that there is low levels of liquidity in other markets. It’s wise to choose a market and an asset that has sufficient interest in order to have a clear exit plan and to achieve a high sales price, but it doesn’t require the hyper levels of liquidity of Manhattan. This allows a smart investor to go into a solid market that may be trading at a higher cap rate than the national average, but may just be off the radar. This is an example of mis-priced risk – there is a higher risk premium than the actual risk. There could be risk factors such as less liquidity, but one can still quantify the sales volume in a given market to understand the liquidity risk and determine the investment has the sufficient risk premium. Taking a higher cap rate and using market rate debt, one can achieve a higher return than would be possible in a more competitive Gateway market.
The key is to find balance. Whether its appreciation, revenue, risk, return, or a number of other factors, understanding the many sides of cap rates will help you arrive at the balance that works best for you.
How can you find a cap rate for a particular market?
Lenders, brokers (perhaps taken with a grain of salt), CPAs, research reports, and surveys will point you in the right direction.