The Capitalization Rate or Cap Rate is a measure of income producing property’s unleveraged interest rate return. The ratio is derived by taking the annual net operating income at the property divided by the property’s value.
Cap Rate = Net Operating Income/Value
EXAMPLE 1 Suppose a property is offered for sale at $3,200,000. The sales broker lists a pro forma NOI of $200,000. The implied cap rate would be the following:
$200,000/$3,200,000 = 0.0625% x 100 = 6.25%
This means that if you purchased the property for $3,200,000 with no debt, and achieved a $200,000 NOI in the first year, you would receive a 6.25% return on your invested equity. The cap rate is a common metric used by brokers, borrowers, lenders and appraisers in real estate. It is easy to understand and a quick metric as to the implied “worth” or “risk” of a property.
One way to understand this better is to remember that there are many investments in which a borrower can invest their money. Suppose the local bank offers a 12-month certificate of deposit (CD) with a 3.25% interest rate. A buyer could put her $3,200,000 in the CD with a near zero risk of losing the money or she could choose to purchase the property and receive 6.25% for a higher risk of losing part or all of her investment. The difference between the 3.25% and the 6.25% is meant to compensate the buyer for the “risk” of the transaction.
Cap rates vary for a variety of reasons. Property condition, location, and type are all factors in a borrower’s immediate risk analysis. A Class-C apartment building in Chicago, IL with a lot of deferred maintenance in a poor location will have a higher cap rate than a Class-A apartment building in a better location. The reason is that the buyer wants to be compensated for the risk of the investment. A Class A property in a good location is highly desirable to rents whereas a Class C property that needs work in a poor location may require time and additional investments to maintain the cash flow. Buyers typically pay more for stable, well maintained assets in good locations thus having a lower interest rate.
EXAMPLE 2 There are two properties with identical NOI – $350,000. Property #1 is a Class C property in a less desirable neighborhood. Property #2 is a Class A property in good location. The buyer is willing to purchase the Property #1 at a 9% cap rate or Property #2 at a 6% cap rate. He would offer the following:
Property #1: $350,000/9.0% = $3,888,888
Property #2: $350,000/6.0% = $5,833,333
As you can see, our buyer is willing to purchase the Class C property but for $1,944,445 less than the Class A property even though they both have the same cash flow. This is because the borrower perceives the Class C property as having a higher risk. The risk can be the location, the property itself as it may need additional investment, the stability of the cash flow or some other metric the borrower decides.
The strength of using a cap rate is that it is easy to understand and it the universal measure by which income producing property is valued. Unfortunately, the biggest weakness is that it is not a stable indicator.
On the micro level, a buyer purchases a property for “x” with cash flow of “y” and yields a cap rate of “z”. This cap rate is most likely comparable to other properties sold at the same time. On the macro level, all of the different properties sold during a specific time are the market cap rate – meaning, the cap rate at which a buyer should expect it needs to pay to enter into that market.
The macro level also shows supply (of buildings for sale) and demand (or available buyers) constraints. If there is a glut of properties for sale then buyers can be picky about which one to invest into and thus drive prices lower and cap rates higher. Alternatively, if there is a lack of buyers for a certain market, a seller may need to lower the price of the property to attract enough demand to get a decent sale.
CB Richard Ellis points out that in the Washington, DC area, cap rates have increased 125 basis points on pro forma income and nearly 300 basis points on in-place income. To illustrate that, assume a Class B property with $475,000 of NOI bought in 2004 at a 6% cap rate is on the market in 2009 at a 7.25% cap rate.
2004 Purchase: $475,000/6.0% = $7,916,666
2009 Sale: $475,000/7.25% = $6,551,724
All else being equal, with the rise in market cap rates, the property seller is losing $1,364,942 or 17% of her invested equity in the Washington, DC market.
A cap rate is strictly a measure of what interest rate for risk investors are seeking at a particular time when purchasing income producing property.
