Education, Finance

What to Know about Cap Rates
for Investment Properties

smartland-what-to-know-about-cap-rates-for-investment-properties.mp3 Investors can expect to pay more for properties with a low cap rate compared to those with a higher cap rate for investment... Listen to this article

Introduction

One of the challenges with evaluating commercial real estate deals is that no two properties are exactly alike. Even two otherwise identical multifamily apartment buildings, constructed at the same time by the same sponsor, will have slightly different locations, tenants and more. It can be hard to make a true “apples to apples” comparison among properties as a result.

Instead, investors will often turn to metrics like “cap rate” for guidance. Analytical tools like cap rate are intended to provide a more objective comparison of properties using financial data.

What is a Cap Rate?

A property’s “cap rate” refers to its capitalization rate. It is one of the most common metrics investors use when analyzing individual deals and their potential profitability. It looks at the ratio between net operating income and purchase price, as further explained below. Cap rates are expressed as a percentage, usually ranging somewhere between 3% and 12% or more.

Cap rates tend to have an inverse relationship to value.
The more valuable a property,
the lower the cap rate and vice versa.

As such, investors can expect to pay more for properties with a low cap rate compared to those with a higher cap rate.

Cap rates are often correlated with a property’s risk profile, as well. “Riskier” properties, such as those in need of substantial renovation or stabilization, tend to have higher cap rates than newer, more fully stabilized properties. However, the increased risk is often associated with the potential for higher rewards, which is again where we see cap rates and potential returns being correlated.

How to Calculate the Cap Rate

The cap rate is simply the ratio between net operating income and purchase price. The calculation is simple:

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Therefore, a property with $500,000 per year in NOI that is purchased for $10 million will be said to have a 5% cap rate ( = $500,000 / $10 million).

Because the cap rate is a ratio of the income to price, it is important to understand what income entails.

To find the NOI, you must first start with the gross rental income. This includes all tenant payments as well as any ancillary income, such as parking fees, laundry fees, storage fees, event or room rental fees, and more. Then, subtract out any vacancy or credit losses, property taxes, property insurance, maintenance and repairs, utilities (if any), and other miscellaneous costs such as management fees. The income left over after these deductions is referred to as the net operating income or NOI.

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Importantly, two costs are not factored into NOI: debt payments and capital expenditures (“CapEx”).

This can be viewed as both a benefit of the cap rate calculation as well as a downside.

For instance, debt and CapEx (i.e., larger property improvements such as roof replacements or unit renovations) are obviously a major cost associated with any real estate deal and therefore, should be captured somehow during an investor’s analysis.

However, because debt and CapEx can vary depending on the sponsor and their specific business plan, it makes doing a comparison of properties more challenging. Therefore, eliminating these as factors in the going-in cap rate calculation allows for a better apples-to-apples comparison of individual properties regardless of sponsor or business strategy.

The purchase price is relatively straight-forward. As you’d expect, it is the actual purchase price of the property. A broker might provide marketing materials that indicate a specific cap rate, but again, that cap rate is based on the listing price and may not be the final going-in cap rate based on the eventual sales price. Therefore, prospective investors should be doing the calculation based on their intended purchase price.

Some investors will factor closing costs and cost of repairs into the purchase price when doing the cap rate calculation. Given that the closing costs and repair costs can vary from property to property, and are often best-guesses, it is usually recommended to use the sales price only when calculating the cap rate when trying to do a side-by-side comparison of two or more investment opportunities.

Factors that Influence Cap Rates

There are many factors that can influence cap rates, either positively or negatively. These include:

  • Location: Well-located properties tend to be considered more valuable than those located in secondary or tertiary markets and therefore, will generally have a lower cap rate than similar properties in less desirable locations. Within the same region, cap rates may vary from one submarket to another depending on the specifics (access, amenities, quality of schools, etc.) of that area.
  • Competition: In areas with substantial competition, there may be downward pressure on rents and a risk of increased vacancy. This competition may therefore impact cap rates. However, competition is not inherently negative. A multifamily investor, for example, might look at an area with many existing apartment buildings and assuming the vacancy rate at these buildings is low, the investor might see this as an opportunity to invest in a new product that lures people from existing buildings. Similarly, an area experiencing significant new construction is usually indicative of demand, which is a signal that strategic value-add investments in existing properties may be worth considering.
  • Property Type: Expectations around cap rates tend to vary depending on the property type (e.g., multifamily, office, retail, hospitality, industrial). Nationally, cap rates on multifamily buildings tend to be lower than office or hospitality, especially in the wake of the COVID-19 pandemic. Meanwhile, we are witnessing a compression among industrial cap rates given current market pressures and a lack of available inventory. In short, what’s considered a “good” cap rate among one property type may be much different than what’s considered a “good” cap rate for another. It is important to put cap rates in the context of property types when analyzing individual opportunities.
  • Property Condition: Real estate assets are generally classified as Class A, B, or C properties with Class A being the newest, best located and most desirable building type. Class C properties tend to be older, with fewer amenities and may require significant improvements before stabilization. Class B properties fall on the spectrum somewhere in between. As it relates to cap rates, Class A properties tend to have the lowest cap rates and may hover between 3-6% depending on the property type. Class B properties will generally trade at cap rates between 6-10% and Class C properties will usually sell at cap rates 8% and above.
  • Market Conditions: Market conditions can also influence cap rates. For example, in a low interest rate environment, investors may be willing to pay a premium for individual properties which will drive cap rates down (unless NOI is correspondingly increasing).

How Investors Use Cap Rates

Cap rates can be valuable to investors for several purposes. Here are the most common ways investors use cap rates when conducting property analyses:

  • Office
  • Retail
  • Industrial
  • Apartments
  • Hotels
How Investors Use Cap Rates
  • Cap rates help investors measure risk. Typically, properties with lower cap rates are considered to be lower-risk investments (and vice versa). This allows investors to evaluate the risk associated with properties across and within individual markets, across asset types (Class A, B or C), and among different property types (multifamily vs. office, for example).
  • Cap rates can be used to identify pockets of opportunity. Let’s say cap rates for multifamily assets in a particular geography tend to hover around 7 or 8 percent. An investor with specific knowledge about that market may view these properties as opportunistic deals. Maybe they know something about the market (e.g., a major employer is planning an expansion or a new transit line is coming to the area) that makes these properties more attractive than they would be otherwise (that’s the beauty of real estate investing, where investors do not operate in a perfectly efficient market). In situations like these, investors might be willing to take on more risk (at least, perceived risk) to achieve a higher return.
  • Cap rates can be used to value a property. Using the inputs to the cap rate calculation, investors can back into a property’s valuation. For example, in a market where cap rates average 5%, a property that generates $500,000 in NOI would be worth approximately $10 million. This is often referred to as the “direct capitalization” method. It requires investors to have a strong sense of the market cap rate, which is a critical input into the calculation. Similarly, some investors have minimum cap rate thresholds they use when evaluating deals, so an investor might determine they are only willing to pay a certain amount in order to achieve that baseline cap rate.

Going-In vs. Exit Cap Rate

There is an important distinction to be made between going-in cap rates and exit cap rates.


The going-in cap rate is the cap rate based upon a property’s current net operating income at the time of sale.

The exit cap rate, meanwhile, reflects the cap rate after property improvements have been made (or not) and the resulting NOI at the time of sale. The exit cap rate may be higher or lower than the going-in cap rate, and is influenced by many factors including the market conditions at the time of both purchase and sale.

A word of caution for investors: some sponsors will try to amplify their return projections by assuming that cap rates will go down during the investment hold period. It is important to look at worst-case scenarios, as well, in case there are market forces that impact cap rates beyond a sponsor’s control.

Most investors will want to be sure there is sufficient cash flow to meet return projections without having to factor in increased asset value.

Here are a few examples of how changes to the cap rate can impact value.

Let’s say a sponsor purchases an apartment building for $5 million. The NOI is $250,000 per year. The resulting cap rate ($250,000 / $5 million) is 5%. The sponsor then executes a value-add strategy, including unit renovations and operational improvements.

Two years later, the NOI is now $350,000 per year. Assuming a constant cap rate, 5% at both the time of purchase and sale, the value of the property will have correspondingly increased. Using the NOI of $350,000 per year / 5% cap rate, the property the sponsor purchased two years prior for $5 million would now be valued at $7 million.

Now, let’s assume the cap rate goes down. In a “falling cap rate” environment, it’s not uncommon to see cap rates compress by 50+ basis points year-over-year. Using the same example as above, let’s say the exit cap rate is now 4.5% based on market conditions. With $350,000 in NOI, at a 4.5% cap rate, the same property would be valued at $7.78 million.

Cap rates investment metrics provide a
useful, quick comparison of investment properties.

Of course, cap rates don’t always increase. Sometimes, they go up during the hold period. Let’s say the 5% going-in cap rate increases to 6% at the time of sale. This could be because interest rates rose, a major employer left, significant new competition came online—the possibilities are endless. In any event, investors now demand a 6% cap rate for apartment buildings of that same caliber (instead of the 5% cap rate at which the property was purchased).

Nothing else with the deal has changed. With $350,000 in NOI divided by a 6% cap rate, the property is now worth $5.83 million. While this represents a slight increase over the $5 million the property was purchased for, it may not represent much of an increase when loan costs, property improvements, and other expenses are factored in.

Investors should consider and be prepared for all scenarios—cap rates remaining constant, going up, or going down between the purchase and exit. We have been in a falling cap rate market for a long time, but it’s unlikely to last forever.

Cap Rate Limitations

While cap rates can be highly useful when doing an initial comparison of investment opportunities, the calculation is also limited. Some of the downsides to using cap rates are as follows:

  • Cap rates don’t factor in debt. Most real estate investments are purchased using some sort of leverage. Factoring in the cost of debt will dramatically impact a project’s overall returns, especially in the early years of ownership or in a high-interest rate environment. For example, any loan with an interest rate higher than 4.25% can create negative leverage in deals with a cap rate of 6% or less. This is because, after making mortgage payments, the cash-on-cash returns will effectively be lower than the 6% cap rate.
  • Cap rates don’t account for capital expenses. We mentioned this above but it’s worth elaborating. Any value-add real estate deal, or office and retail deals that require tenant improvements prior to leasing, will generally carry a substantial CapEx budget. The NOI simply does not account for these CapEx costs. At smaller properties with lower income, a significant capital expenditure can have an oversized impact on the project’s cap rate.
  • Cap rates don’t factor in market rent growth. Many properties in major metropolitan areas see much lower cap rates than those in smaller cities or in suburban and rural areas. For example, on the surface, a 7.5% cap rate in Cleveland might appear to be a “better” cap rate than a 4.5% cap rate in San Francisco, but this fails to consider the potential for rent growth in San Francisco (likely higher) relative to that in Cleveland (likely lower), which will influence cap rates over the long-term.
  • In order for a cap rate calculation to be accurate, it assumes the NOI provided by the seller is accurate. While the NOI provided by the seller can be useful, it is not always highly accurate. Some sellers have more or less sophistication than others in terms of their record-keeping and accounting. Moreover, when a property sells, there will usually be an increase in local property taxes which will also need to be reflected in the NOI post-closing. Prospective buyers will want to comb through the NOI provided by the seller and do a gut-check as to whether the numbers seem realistic or not.
  • Cap rates only provide a snapshot in time analysis. In practice, NOI will vary from year to year based on many factors, such as vacancy, rent collections and more. The cap rate does not capture these periodic fluctuations. Instead, it provides a simple snapshot in time analysis based on two otherwise simple data points (NOI and purchase price).

Conclusion

Cap rates are undeniably one of the most widely used investment metrics. They provide a useful, quick comparison of investment properties. However, for them to be most effective, an investor will want to closely examine what is driving the cap rate for any individual property and whether there is an opportunity to improve the cap rate through strategic investments.

Investors will often turn to metrics like “cap rate” for guidance.
Analytical tools like cap rate are intended to provide
a more objective comparison of properties using financial data

Are you interested in investing in commercial real estate? Contact us today to learn more about Smartland’s platform, our approach to cap rates, and how we seek to improve value for investors over time.


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