Welcome back! Today we will cover one of the most controversial topics in commercial real estate – cap rates. We will, however, leave the politics aside and will instead focus on demystifying cap rates – meaning, drivers, and valuation impact.

In simple terms, the cap rate (aka the capitalization rate) represents the rate of return on a real estate investment property based on the income such property generates/is expected to generate.

Cap Rate = Net Operating Income / Property Purchase Price
Conversely, if one has the Net Operating Income generated by the property and the market cap rate, one can back into the potential valuation of the property (we will dive into Net Operating Income in another quick tip article).

Some people refer to the cap rate as the unlrevered rate of return, as it is based on net operating income (vs. cash flow after debt service). Others refer to it as the inverse of the price-earnings multiple.

The cap rate can be affected by a number of factors – underlying economic or market fundamentals, interest rates, demand for and supply of the underlying asset, asset class, location, building age and condition, etc. For example, an older property located in a tertiary market is likely to have a higher cap rate vs. a newer property located in a secondary market. A multifamily (apartment building) property will have a different (usually lower) cap rate relative to hotels or office buildings. In a competitive market environment where demand exceeds supply (like the market conditions today), increasing competition and hence higher prices will further drive cap rates down.

Usually the higher the risk profile of the asset, the higher the expected cap rate will be.
If one thinks of the 10-yr T-bill as being the risk-free rate of return, the difference between the cap rate and the T-bill rate (aka the spread) will reflect the risk premium one receives for investing in the subject asset class. In an effort to predict cap rates, many would usually observe the 10-yr Treasury Bill. As a point of reference, the long-term average spread for apartments is approx. 200 bps (2.00%).

With that said, data suggests that the relationship between the 10-yr US Treasury rate and cap rates is not necessarily correlated (I will let my statistician friends go through the exercise of proving that empirically). While usually cap rates may trend upward as interest rates rise, that rise does not always occur at the same pace. In addition, a period of rising interest rates does not necessarily mean cap rates will increase. For example, if real estate as an asset class remains preferable due to growth or inflation expectations or due to its better risk profile relative to other alternatives, then the spread can compress instead.

Another point of comparison that some people observe is between the cap rate and the loan interest rate. If the cap rate is lower than the loan interest rate, it simply puts you on notice to be careful of overleverage.

In the current market environment, as competition for properties is increasing and has bid prices up, we have observed an overall cap rate compression. In addition, cap rate spread compression is observed
among asset types (Class A vs. Class B vs. Class C), leading operators today to purchase Class C assets and nearly Class A cap rates (we will cover asset class definitions in a separate quick tip article).

As you evaluate a property’s projected performance, pay special attention to the cap rate assumptions. While no one has a crystal ball to predict exactly where cap rates will be 3-5-7 years from now, given the current compressed levels (and other economic fundamentals), it is likely they will rise at some point. Even a few basis points difference in cap rate can make a meaningful impact on a property’s valuation. Thus, you should understand what cap rate assumptions a sponsor is applying as they perform property proforma valuations, which ultimately also factor into return fundamentals such as IRR (see the prior quick tip article on this). It is prudent for a more conservative operator to assume a 10 bps cap rate increase annually throughout the projection period.

I know this was a lot digest, so we shall stop here. I hope you found the above overview helpful and now feel better equipped with yet another tool (metric) to evaluate properties. And if you want to have some fun, mention cap rates next time you speak with real estate investors and you can look forward to an engaging conversation with a multitude of views and opinions.

Should you have any questions or want to learn more about real estate investing, please reach out to info@dbacapitalgroup.com.

Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.