When underwriting a real estate investment opportunity, forecasting the property’s sales price can be tricky for two reasons. First, the sale is an event that may not happen for five or ten years. Second, it can be very difficult to forecast economic conditions this far into the future. However, one of the commonly accepted ways to make this estimate is to apply a “residual cap rate” to the property’s projected net operating income (NOI) in the final year of the holding period.
In this article, we will define what a residual cap rate is, why it matters, how to estimate it, and how it can impact investment returns. By the end, readers will be able to estimate the residual cap rate on their own and use this technique to perform their own investment property analysis.
At First National Realty Partners, we use the residual cap rate as part of our pre-purchase due diligence program. Its proper use allows us to identify the deals that offer the greatest return potential for our investors. To learn more about our current investment opportunities, click here.
What Are Cap Rates?
A commercial property’s capitalization rate – cap rate for short – is a real estate investment performance metric that describes the relationship between net operating income and value. The cap rate formula is:
Cap Rate = Net Operating Income / Property Value
The result of the calculation provides real estate investors with two key pieces of information:
- It provides an indication of an investor’s annual rate of return, assuming the property is purchased with cash.
- It also provides real estate investors with an indication of the market’s assessment of risk in the property. A higher cap rate means more risk, which is why investors need a higher return. A lower cap rate means less risk, which is why investors are comfortable with a lower return.
When creating a real estate investing proforma, the cap rate is particularly important at two points in the transaction, the beginning and the end. In the first year, the cap rate can be used to determine a fair purchase price for the property. This is sometimes referred to as the “going in cap rate” or “acquisition cap rate.”
At the end, the cap rate can be used to estimate a potential sales price. This variation is sometimes referred to as the “terminal cap rate,” “exit cap rate,” or “residual cap rate.”
What is the Residual Cap Rate?
The residual cap rate is the cap rate that is used in the final holding period of a real estate investment pro forma to estimate the sales price of a property.
How to Calculate Residual Cap Rate and Terminal Value
The residual cap rate calculation is the same as the formula described above, but it uses the final year net of net operating income and the estimated market value at that time. The updated formula looks like this:
Residual Cap Rate: Final Year of Net Operating Income / Projected Market Value at the end of the holding period
Tactically, the residual cap rate is not typically calculated this way. Instead, it is estimated based on the sales of similar properties with an adjustment for how it might change over the course of the holding period. When used this way, the above formula needs to be rearranged to calculate the property’s terminal value (the sales price):
Terminal Valuation: Final Year of Net Operating Income / Residual Cap Rate Estimate
To illustrate how this works, suppose that a property is projected to have $100,000 in net operating income in the final year of the holding period and research has revealed that similar properties sell for a 6% cap rate. In this case, the terminal value is $1.6MM ($100,000 / 6%).
Factors That Influence The Residual Cap Rate
The residual cap rate estimate for a rental property is influenced by a variety of factors, many of which are estimated at the time of purchase for some future date. They include:
- Property Type / Asset Class: Different property types tend to have different risk profiles. For example, multifamily properties are generally considered to be on the less risky end of the spectrum so they have lower cap rates. Properties like hotels and restaurants are at the higher end of the risk spectrum, so they tend to have higher cap rates.
- Real Estate Market / Location: Highly sought after markets (like New York) tend to come with lower cap rates than secondary or tertiary markets like Omaha or Des Moines.
- Rental Income / Expense Growth: Properties with high income growth and relatively stable operating expenses tend to come with lower cap rates than properties with low or no income growth and volatile expenses.
- Tenants & Leasing Activity: Properties with high quality tenants and high demand for space tend to have lower cap rates than properties with lower quality tenants. In addition, tenants who have longer term leases tend to command lower cap rates than those with tenants whose leases expire soon after purchase.
- Market Conditions: This is perhaps the most difficult component to project because so much can happen in five or ten years. Projections for deteriorating market conditions lead to higher cap rates while estimates for strong market conditions would skew the residual cap rate estimate lower. In this instance, analysts are incentivized to be conservative about their market condition estimates.
Regardless of the factor, the important point here is that the residual cap rate is often an estimate made at the time of purchase about something that is several years into the future.
Why Residual Cap Rate is Important
Although just an estimate, getting the residual cap rate right is important for two reasons:
- As described above, it is used to calculate an investment’s residual / terminal value.
- The resulting terminal value has a material impact on the potential return on investment / profitability that the property delivers. In fact, terminal value often delivers the bulk of the returns for an investment.
If the residual cap rate estimate turns out to be inaccurate, there are two potential outcomes. On the positive side, if the estimate was high and the actual terminal value ends up being more than the estimate, investor returns can have an upside surprise. Conversely, if it ends up being low and the property does not sell for the expected amount, real estate investors can end up being disappointed with the actual return.
Summary & Conclusions
Residual cap rate is a commercial real estate term used to refer to the cap rate that an investment property commands upon sale. It is calculated as the estimated net operating income in the final year of the holding period divided by the then current market value of the property.
In practice the residual cap rate is usually estimated based on the cap rates achieved in the sales of similar properties. These cap rates are impacted by a variety of factors including: property type, market conditions, and location.
In a financial model, the residual cap rate is important because it helps investors calculate the residual or “terminal” value of a property.
The terminal value – the price the property is sold for – often makes up a major component of investment returns. If the residual cap rate estimate is inaccurate, actual property returns can be materially different from the original estimate.
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.