There are two primary drivers of commercial real estate prices, a property’s Net Operating Income (NOI) and the capitalization rate (“cap rate”) that is applied to it.
The NOI calculation is fairly straightforward, gross income less operating expenses in any given year.
The formula used to calculate the cap rate is also straightforward, but the result can be anything but. Within this single metric, a lot of information is implied and it is important for investors to understand what it means.
What Exactly is A Cap Rate?
In commercial real estate investing, a capitalization rate is the rate of return that an investor could expect if a property was purchased in cash. The formula used to calculate it is:
Cap Rate = Year 1 Net Operating Income / Purchase Price
For example, if a property has NOI of $100,000 and a purchase price of $1,000,000, the resulting cap rate is 10% ($100,000 / $1,000,000). However, a property’s purchase price/market value is not always known so the equation can be rearranged to find it if the cap rate is known:
Price = Year 1 Net Operating Income / Cap Rate
In this example, $100,000 in NOI and a 10% cap rate would result in an estimated value of $1,000,000.
Again, the calculation of a cap rate is fairly simple, but the assumptions behind it are much more complex
What Are The Assumptions Behind The Cap Rate?
In many ways, a commercial real estate investment property is similar to a perpetuity, which is a theoretical income stream that continues indefinitely. As a result, the formula used to calculate a cap rate is very similar to the formula used to calculate the value of a perpetuity. It is:
Perpetuity Value = Annual Income / Expected Rate of Return
For example, assume that an investor expects to earn 8% on annual income of $75,000. The amount they would be willing to pay for this stream of income is $937,500 ($75,000 / 8%). Like the cap rate formula, the perpetuity formula can also be rearranged to calculate the expected rate of return if the perpetuity price is known. For example, if the price of the perpetuity was $937,500 and it is known that the annual income will be $75,000, the rate of return can be calculated as 8% ($75,000 / $937,500).
This formula works because, in theory, a property’s cash flow can extend forever. However, it isn’t this simple. Real estate is a physical asset whose condition degrades over time and cash flows can be variable from year to year. This means that the cap rate is driven by two key variables, expected investment returns and cash flow growth over time. Each is discussed in detail below.
What Are Expected Returns?
Every investor has their own set of unique set of return requirements. One investor may be willing to accept a lower return to have a stable series of cash flows. Another may be willing to take more risk in pursuit of a higher return. Thus, the expected rate of return, sometimes referred to an investor’s required rate of return, is the return on an investment that an investor requires given the unique features of a property, cash flow volatility, and availability of alternative investments.
The tricky part about the expected rate of return is that they can change and they can differ from one investor to another. When they do, it has an impact on the perceived value of the property. For example, assume that two investors both looked at the same property that produces $100,000 in Net Operating Income. Based on their assessment of the risk, one requires a return of 7% while the other requires 8%. The amount they would be willing to pay for that series of cash flows is:
Investor 1: $100,000 / 7% = $1,428,571
Investor 2: $100,000 / 8% = $1,250,000
From this calculation, it can be inferred that investor #1 perceives lower risk and thus is willing to pay a lower cap rate (higher price). Conversely, investor #2 likely sees more risk, so they require a higher return, and thus are willing to pay a higher cap rate (lower price).
One of the key factors that drive the required return is the expected growth rate of income.
How Does The Income Growth Rate Impact the Expected Return?
Remember, a commercial property’s value is based on the amount of annual Net Operating Income that it produces. One of the best perks of owning commercial real estate is that NOI tends to grow over time through a combination of market forces, built in lease escalations, and management practices.
Even without any changes in the cap rate, property value (and potential returns) can change significantly with increases in Net Operating Income. To illustrate this point, consider a property with a cap rate of 7%. Using the same cap rate calculation, every $1 increase in NOI results in a $14.28 increase in property value ($1 / 7%). Now, imagine this calculation at scale. Suppose a commercial apartment building or office building has year 1 NOI of $100,000. Through a combination of lease escalations, market dynamics, and cost savings strategies, NOI increases to $175,000 by year 10. At a 7% cap rate, this additional $75,000 in NOI adds $1.07M to the property’s value.
So, the higher the property’s expected income growth rate, the more an investor will be willing to pay for that income stream in the present.
Other Factors Influencing the Cap Rate
Aside from those mentioned above, there are a number of other factors that could potentially impact the cap rate of real estate and they all have to do with the perceived risk associated with acquiring the property. They include:
- Length of Existing Leases: If the existing tenants have many years left on their leases, the property’s rental income stream is more predictable and less risky. If a tenant, especially a major one, has just one or two years left on their lease, the property is more exposed to both vacancy and income risk. Longer leases equal less risk and lower cap rates. Vice versa, shorter leases equal higher risk and higher market cap rates.
- Replacement Cost: A property’s replacement cost is the amount of money it would take to rebuild it from scratch. The bigger a discount to replacement cost that a property is purchased for, the less the perceived risk and the lower the cap rate.
- Real Estate Market Conditions: Conditions can vary widely from one market to another. For example, a high growth market like Central Florida is likely to command lower cap rates than a slower growth market in Iowa.
- Tenant Strength: If a property is filled with high quality tenants that can be depended upon to make their rent payments, there is less risk than a property with local tenants who have unknown financial strength. For example, a Walgreens or McDonalds is always going to command a lower cap rate than a property with a local coffee shop and restaurant.
- Property Type & Asset Class: Different property types tend to be valued using different cap rates because of their unique risks. For example, a Class A multifamily property tends to be valued with a lower cap rate than a value-add retail shopping center because the perceived risk is lower.
Each of these factors contribute to the selection of the cap rate used to value a property. The result – and the return it implies – is a key data point in the investment strategy and investment decision for a given real estate asset.
How To Mitigate Cap Rate Risk
A cap rate is dynamic, meaning that it changes over time. Unfortunately, there is no way to know for sure where they are headed in the future, but there are three steps that can be taken to mitigate the risk that they rise over the investment holding period:
- Don’t Overpay: The sales price for a rental property should be based upon comparable prices for similar properties in the same market. Paying more than the current market value in the present can negatively impact the return on investment in the future.
- Make Conservative Proforma Assumptions: The proforma for the investment opportunity should, at a minimum, assume that a property is sold for the same cap rate used to purchase it. An even more conservative assumption is that it drifts higher throughout the holding period. For example, a 6% entry cap rate may drift up to a 6.5% cap rate in the proforma sale assumptions.
- Add Value: Real estate investors and property owners should actively add value throughout their stewardship of the property. Ideally, the value-add actions result in higher net operating income and a corresponding higher valuation at sale.
It is not possible to completely eliminate cap rate risk, but the steps above will help to reduce it to a manageable level.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 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.