Is The Cap Rate a Before Tax or After Tax Metric?
One of the metrics that real estate investors use to measure a property’s potential return is the capitalization rate, or cap rate for short. This is a useful and versatile metric that serves as the basis for many commercial real estate investment decisions.
In this article, we are going to discuss what the cap rate is, how it is used, why it is important, and whether it is a before tax or after tax metric. By the end, readers will have a better understanding of the cap rate and will be able to apply this knowledge to their pre-purchase investment property due diligence process.
At First National Realty Partners, we pay close attention to the cap rate and use it as a screening tool to help us find the best properties for our real estate investors. To learn more about our current investment opportunities, click here.
What is The Cap Rate?
Calculating the Cap Rate
The formula used to calculate the cap rate is:
Cap Rate = Net Operating Income / Asset Value
Although this formula is relatively simple, the inputs needed can be a bit more complex because they may not always be known at the time the cap rate is being calculated.
In the numerator, Net Operating Income is calculated by subtracting a property’s operating expenses (property taxes, insurance, depreciation, maintenance, property management, etc) from its gross income. In most cases, this information can be obtained from a property’s historical operating statements and can be projected forward using assumptions about income and expense growth.
Value can be represented by a variety of options including the purchase price, a market based estimate, or a third party appraisal.
What Information Does The Cap Rate Provide?
The cap rate is a versatile real estate metric because it can provide several pieces of valuable information in a single number, including:
- Rate of Return: Mathematically, the cap rate represents the annual rate of return for a property assuming that it was purchased with cash. For example, if a property produces $100,000 in annual NOI and has a value of $1MM, the resulting cap rate of 10% means that an investor could expect a 10% annual return on their $1MM cash purchase.
- Risk: The cap rate also signals the market’s assessment of risk for a given property. A higher cap rate signals a riskier property and a lower cap rate signals less risk. For example, a 100% occupied property with a 25 year lease is considered to be far less risky than a 50% occupied office space with tenants on month to month leases. So, it could be expected that the former property would fetch a lower cap rate (higher purchase price) than the latter.
- Expected Future Growth: Somewhat related to risk, properties for which growth in net operating income is fairly certain tend to sell for lower cap rates than those for which it is uncertain. Continuing the example above, the 25 year lease may have 1.5% increases built into the rental rate annually whereas the half empty office building has no such certainty. As a result, the property with the longer leases and the built in increases will sell for a lower cap rate.
For context, there is no such thing as an objectively “good cap rate” or “bad cap rate” because this measurement is relative to each real estate property and market. That said, a low market cap rate for a safe rental property like a Class A multifamily apartment building could be in the 4% -6% range. At the other end of the spectrum, a cap rate for a higher risk property like a half full office building could be 10% or more.
Is The Cap Rate A Before Tax or After Tax Metric?
The cap rate is a before tax metric. To understand why this is the case, it is helpful to have a basic understanding of how a property’s income and expenses are projected. These projections are made using a document called a proforma, which has a similar format for all commercial property types. The basic construction looks like this:
|Effective Rental Income
|Combined rental income from all units
|Gross Operating Income
|Rental income less vacancy, plus all other sources of income like fees
|Total Operating Expenses
|Sum of operating costs like taxes, insurance, maintenance, etc.
|Net Operating Income
|Gross Operating income minus total operating expenses
|Loan payment based on principal balance, interest rate, and amortization
|Cash Flow Before Tax
|Net operating income minus loan payment
|Taxes, as calculated based on income bracket
|Cash Flow After Tax
|Cash flow before tax minus cash flow after tax
In the table, it can be seen that a property’s net operating income, sometimes called pre-tax cash flow, is calculated before taxes. Since this is a required input in the cap rate formula, it can be safely concluded that it is a before tax metric.
Why Calculating the Pre-Tax Cap Rate is Important
Since the cap rate calculation provides an indication of a property’s return on investment, it may be counterintuitive for it to be calculated on a pre-tax basis. But, it is important for two reasons, efficiency and consistency.
First, since net operating income is one of the inputs in the cap rate formula, on some levels the cap rate is a measure of short term (annual) operating efficiency. The more NOI that a property produces relative to its current market valuation, the more efficiently a property is operated. For real estate investors, this can be a way to separate good deals from bad ones.
Second, and perhaps most importantly, the cap rate of a property is calculated on a pre-tax basis because it allows real estate investors to compare the returns for similar properties, regardless of size. This can only be done on a pre-tax basis since deal structures and individual tax brackets are likely to vary from deal to deal.
Summary & Conclusion
Cap rate in real estate provides investors with information on expected annual returns, market risk, and income growth rates. It is calculated as net operating income divided by the current market value of the property.
Net operating income, which is one of the inputs in the cap rate formula, is a pre-tax metric which means that the cap rate is also a pre-tax metric.
Calculating the cap rate for every property is an important part of a broader investment strategy because it provides helpful information about a property’s operating efficiency and allows real estate investors to compare this efficiency across different properties, markets, and asset classes.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.