- To estimate their potential returns on an investment opportunity, commercial real estate investors use a variety of metrics. Two of the most important are the Capitalization Rate (“Cap Rate”) and Return on Cost.
- A property’s Capitalization Rate is an estimate of the annual return in an all cash purchase. It is calculated as the Net Operating Income divided by the Purchase Price (or est. Market Value).
- A property’s Return on Cost is similar to the Cap Rate, but it is forward looking and takes into account potential changes to Net Operating Income. It is calculated as Purchase Price plus Renovation Expense, divided by Potential Net Operating Income.
- Both metrics have their pros and cons and should be viewed as complementary to each other, particularly in a value-add investment.
Whether they focus on commercial or residential property, every real estate investor has their own set of return requirements that they use to determine whether or not an investment property is worth purchasing. In the commercial real estate investing space, there are two widely used methods of measuring returns. One is the Capitalization Rate (“Cap” Rate) and the other is Return on Cost. They each have their own strengths and weaknesses, but both are useful when evaluating a property’s risk/return profile. They are each described in detail below.
What is a Capitalization Rate (Cap Rate)?
A property’s Capitalization or “Cap” Rate” is a term that represents the ratio of a property’s Net Operating Income to its purchase price. Mathematically, the formula is:
The result of the calculation is expressed as a percentage, but, it’s what the Cap Rate represents that may be more important. Intuitively, it represents the “rate of return” that an investor could expect on an all cash purchase of a property in the first year of ownership. For example, if a property generates $1 million in Net Operating Income (NOI = total income minus operating expenses) in year 1 and the purchase price was $15 million, the resulting cap rate of 7% represents the year one annual return.
However, it is important to note that the Cap Rate only measures one point in time and it could represent different streams of cash flow. It could represent the trailing 12 months NOI, in which case it would be referred to as the “trailing Cap Rate.” Or, it could represent the anticipated year 1 cash flow, in which case it would be referred to as the “initial Cap Rate.” It is always important to specify which one is used.
While the calculation itself may be simple, the logic behind it is anything but. The denominator in the equation, Purchase Price, can be influenced by a variety of factors including location, tenant base, rental rates, and in-place leases. For example, a property located in a strong market like Denver with long term leases in place and financially secure tenants is likely going to sell for a higher price than a similar property located in Omaha with short term leases and marginal tenants.
When to Use the Cap Rate
There are three distinct scenarios where the cap rate calculation can be very useful in determining an individual’s investment strategy:
- Property Comparison: When making investment decisions with two similar properties, their respective Cap Rates allow for a quick comparison. If one has a good cap rate of 5% and the other has a higher cap rate of 10%, the risk premium for the second property implies that there is some sort of issue with it that warrants a lower price and/or closer inspection.
- Trend Comparison: Studying the trend of cap rates in a particular real estate market can be a useful indicator for how the market perceives the asset or asset class. If the cap rate trend is down (which is good), it could be an indication of strong demand and a clue as to where market values are headed.
- “Back of the Envelope” Calculations: Rearranged, the formula for the Cap Rate can also be used to make a back of the envelope calculation for purchase price or valuation if the NOI is known. For example, if we are evaluating a property where the NOI is $100,000 and we know that the cap rates for similar properties in the same market are around 7%, we can quickly estimate a potential market value of the property of $1.42 million.
As useful as it is, there are some limitations to using the Cap Rate as a way to estimate a property’s purchase price and/or potential return. If the target property has irregular cash flows or, if it is a value add opportunity, Cap Rate isn’t very useful because it depends on consistent cash flows. For example, the income for an obsolete multifamily property with 40% occupancy probably isn’t enough to cover expenses, resulting in a negative Cap Rate. However an investor may view this as an opportunity to purchase the property, repair it, and lease it up, resulting in a series of increasing cash flows – and cap rates – over time. Where the cap rate may have been negative at the time of the acquisition, it may end up in positive territory when the repairs and stabilization are complete. In such a scenario, the Return on Cost may be a more valuable metric.
Return on Cost
Return on Cost is similar to the Cap Rate, but is forward-looking because it accounts for the costs needed to stabilize a rental property and the resulting NOI once stabilized. Mathematically, the formula for calculating Return on Cost is:
Notice that the denominator in the equation is potential NOI, which may be two or three years in the future, once renovations are complete and the rental income has been boosted to increase the return on investment.
Return on Cost is useful because it allows an investor to compare the return that they may earn on a series of stabilized cash flows today to the annual income that they could earn in the future. Or, put another way, it is useful to try and determine if it is more advantageous to pay more to purchase a property with stabilized cash flows or pay less for a property that could potentially have higher cash flows. To illustrate this point, consider the example below where an individual is deciding between two different investment options.
For example, suppose an investor is thinking about paying an asking price of $10 million for a 100% occupied, fully stabilized apartment building that generates $1 million in NOI today, implying a 10% Cap Rate ($10,000,000 / $1,000,000). Or, the investor could purchase a value-add property with 60% occupancy for $7 million that needs $3 million worth of work. At the time of purchase, the property has $600,000 in NOI, but once the renovations are completed, it will produce $1.2 million in NOI. Using the formula above, the Return on Cost is 8.33% ($7,000,000 + $3,000,000 / $1,200,000). So, for the same initial investment of $10 million, the investor is able to purchase a larger stream of income in the future. Applying the same 10% cap rate to the $1.2 in future NOI implies a value of $12 million. By purchasing the asset with more risk and executing a successful turnaround plan, the investor has turned the same $10 million investment into a larger profit.
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.
We use both the Return on Cost Cap Rate formulas to evaluate potential investments. If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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