In addition to a multi-decade career spanning law, investment banking and teaching, Simon was most recently CFO of Common Living and a member of the board of directors of Bank Leumi USA. Capitalization rates (“Cap Rates”) are ubiquitous in the world of real estate. Rarely, if ever, will you receive marketing materials from an investment sales broker that do not reference an “attractive cap rate.” If you corral a group of real estate professionals in a room, you will likely get no disagreement on the de nition of a Cap Rate.
However, you may very well nd disparate https://www.thesisdriven.com/p/understanding-cap-rates 1/13 views on the information it conveys, its proper use, and whether it is a crucial element in determining the value of income producing real estate. Like price/earnings (“P/E”) ratios in corporate nance, cap rates serve a real purpose but are o en misunderstood and misused. In this letter, we will: 1.
Review the de nition of a Cap Rate; 2. Explore the basic math underlying the concept; 3. Discuss the similarities to P/E ratios and what those similarities teach us; 4.
Examine the uses and misuses of Cap Rates; and 5. Conclude with a discussion of how Cap Rates t into the real estate nance toolbox. The Cap Rate is most typically de ned as “the return on an investment anticipated by the buyer in the rst year of [property] ownership.” Expressed somewhat di erently, a Cap Rate “is essentially the expected rst year income yield on an income property investment.” This is sometimes shortened to “the rst-year cash-on-cash return.” Regardless of the language used, there is agreement on the actual calculation: The Cap Rate is calculated as the ratio of a property’s forward net operating income (“NOI”) to its current fair market value (“MV”).
This is all pretty straightforward. Let’s dive a little deeper. If we do a little algebra and rearrange the Cap Rate formula, we arrive at a formula that is signi cantly more interesting and potentially useful: https://www.thesisdriven.com/p/understanding-cap-rates 2/13 This appears to tell us that the “market value” of an income producing property is determined by dividing the NOI by the Cap Rate.
Is it really that simple? Is a property’s “value” a function of a single year’s NOI divided by the Cap Rate? The answer is most de nitely “No” and here is where it gets a bit more nuanced.
The MV formula above is mathematically identical to the formula for calculating the present value (“PV”) of a xed perpetuity. What we are calculating in the formula above, whether we are aware of it or not, is the PV of a perpetual stream of NOI discounted at a rate equal to the Cap Rate. But while this formula may look like a proper valuation tool it is de cient in important respects.
It is a fundamental tenet of nance—whether corporate nance or real estate nance or anything else—that the value of a nancial asset (excluding non-income producing assets such as works of art, vacant land, or gold) is equal to the present value of the expected cash ows generated by that asset discounted back to the present time at a discount rate re ecting the risk level of the investment. In the special case where the future cash ows are constant and perpetual, the formula is exceedingly simple: where CF is the cash ow and r is the discount rate of future cash ows. This looks very much like our MV formula!
In place of cash ow, we are using NOI as the numerator, and the Cap Rate is our given discount rate. We can see that our MV is really the present value of a xed level of NOI generated in perpetuity and discounted back to the present at the Cap Rate. But while these two formulas are very similar, there are several crucial di erences.
First, NOI is not equivalent to cash ow. NOI is calculated by taking gross rental income and https://www.thesisdriven.com/p/understanding-cap-rates 3/13 deducting operating expenses. While depreciation (which is not a cash expenditure) is not deducted in calculating NOI, neither are leasing fees or capital expenditures (“CAPEX”).
These are both current period uses of cash that need to be subtracted from NOI to arrive at cash ow. Second, our perpetuity formula assumes that the cash ows are constant and perpetual. But it is almost always the case that gross rental income will increase going forward as the result of escalating rental charges.
The extent to which this will result in increased NOI depends on how much operating expenses also increase. And obviously the level of free cash ow will vary with the future required CAPEX. The important point is that the PV formula must be modi ed to re ect projected future changes in cash ow: where g is the expected annual rate of increase in the level of cash ow.
Two conclusions can be drawn from this discussion: 1. Discounting a xed level of NOI at the Cap Rate is not an appropriate approach to determining the true economic value of income producing real estate. NOI is not cash ow and assuming a xed level of NOI in perpetuity is neither realistic nor appropriate.
2. The Cap Rate is not equivalent to the expected nancial return from an investment. The total unlevered return from an investment will be better approximated by a formula that takes account of the initial (“going-in”) Cap Rate, the projected normalized level of CAPEX, NOI growth as well as the Exit Cap Rate.
See the National Council of Real Estate Fiduciaries (Semi-annual Webinar, November 2011). https://www.thesisdriven.com/p/understanding-cap-rates 4/13 Given the signi cant de ciencies of using Cap Rates to determine valuation, what use do Cap Rates have? Here we can return to the analogy made to P/E ratios.
If we think of earnings and NOI as being roughly equivalent (putting aside the issue of depreciation that a ects earnings but not NOI), then there is a very close relationship between P/E ratios and Cap Rates. In fact, Cap Rates are nothing more than reciprocal P/E ratios. Cap Rates are de ned as NOI/MV.
If we substitute earnings for NOI and PRICE (“P”) for MV we get E/P, which obviously is the P/E ratio turned on its head (o en referred to as the “Earnings Yield”). In corporate nance, P/E ratios are used to value companies “relative” to other comparable companies. While P/E ratios can be determined simply by observing a company’s current share price compared to its level of earnings, on a more fundamental level P/E ratios are determined by a company’s expected growth rate in earnings as well as its projected return on equity.
It is only when P/E ratios are adjusted to take account of these two factors that comparisons of companies based upon P/E ratios yield useful information. Similarly, using forward NOI and a Cap Rate to determine the value of income- producing real estate only makes sense as a tool of “relative valuation” when comparing https://www.thesisdriven.com/p/understanding-cap-rates 5/13 properties in the same category (e.g. multifamily; o ce; retail; storage; hospitality) and geography that have similar projected CAPEX as well as similar projected expense ratios and rates of growth in NOI.
In that circumstance, using a Cap Rate and a single level of NOI “on the back of an envelope” can provide insight into the properties being compared. From a Realty Mogul analysis of the shortcomings of Cap Rates: Cap Rates are intended to be used to compare stabilized assets to other stabilized assets in a speci c market. Cap rates assume that all of the properties in a comparative set have near market occupancy, market rents and expense factors, in order to create a baseline average capitalization rate for the market.
Historical CMBS Cap Rates by Sector From the foregoing discussion we can draw some conclusions regarding the use and misuse of Cap Rates. At the outset we referred to the well-established practice of https://www.thesisdriven.com/p/understanding-cap-rates 6/13 investment sales brokers to reference Cap Rates in marketing commercial real estate sales. An investor should understand how this number is calculated and recognize that it does not represent the expected return—even unlevered—from the proposed deal.
Feel free to use the Cap Rate as a tool to compare the asset to others in the same market. But make certain that the comp set is just that—composed of similar properties with similar characteristics in terms of asset class, operating margins, Capex, and projected growth. While an investor is ill-advised to rely exclusively on Cap Rates to determine the going- in value of a real estate asset–or to project an expected return–Cap Rates can be used more con dently when determining an exit from a real estate investment.
At the time of acquisition, the investor is trying to determine the projected return from the property, adjusted for risk. The salient issue is what the “value” of a property is and whether the market is overvaluing or undervaluing the property. But in modeling a sale at the end of a projected holding period, the only real issue is what the market is willing to pay.
The investor’s thinking on value, return, risk etc. is interesting but not determinative. Of course, forecasting Cap Rates ve, seven, or ten years in the future is fraught with its own complexities and di culties.
Here again our analogy to P/E ratios is helpful. Market multiples used in corporate nance are hard to predict. Cap Rates also change for a myriad of reasons—having to do with asset quality, the local real estate market, and macroeconomic factors including interest rates, in ation, and overall investor sentiment.
While Cap Rates typically move with interest rates—not surprising given that all discount rates are premiums on the “risk-free rate” which is generally determined by the current yield on the 10-year US Treasury Note—this is not always the case. https://www.thesisdriven.com/p/understanding-cap-rates 7/13 The best advice is to proceed cautiously and be aware that assumptions regarding exit Cap Rates will have a major (perhaps overwhelming) impact on valuation. When underwriting, an investor can pretty much get any desired result by making reasonable- sounding assumptions regarding Cap Rates.
Don’t fool yourself! https://www.thesisdriven.com/p/understanding-cap-rates 8/13 Kasa Founder and CEO Roman Pedan authored a detailed discussion of exit Cap Rates —particularly in the context of the short-term rental market—on Thesis Driven last November. Cap Rates certainly have a meaningful role to play in the nancial analysis of real estate.
However, their proper use requires an understanding of how they are calculated and the limitations that result. Real estate professionals use numerous tools to calculate value and project returns from real estate investments; Cap Rates are just one. From 2014-2022 I was a member of the Loan Committee and Chairperson of the Risk Management Committee of Bank Leumi USA.
During that period, we reviewed dozens if not hundreds of loan requests linked to real estate. Transactions ranged from acquisitions of stabilized multi-family properties to construction nancing for projects costing well over $100 million. Appraisals were an integral part of almost every https://www.thesisdriven.com/p/understanding-cap-rates 9/13 transaction and appraisals—whether internal or prepared by third-party appraisal rms —almost always utilized several di erent methodologies: The cost approach endeavors to ascertain the construction cost of an existing property including all improvements and then adjust it for depreciation.
A pro t margin is built in which allows the appraiser to estimate the total value. The comparable sales approach is just that. Of course, the challenge is nding relevant comps and then adjusting them for di erences in location, size, nishes, amenities etc.
The capitalization approach is essentially the Cap Rate approach. NOI is calculated for existing properties and projected for redevelopment or ground-up construction and then the appropriate capitalization rate is applied. The yield capitalization method utilizes a discounted cash- ow (“DCF”) model.
Projected cash ows are developed using appropriate assumptions regarding gross rental income, operating expenses, CAPEX, and other cash expenditures, as well as exit or reversionary values. All the projected cash ows are discounted at a rate re ecting the current long-term risk-free rate (perhaps normalized to adjust for current actions of the Federal Reserve) as well as a proper spread considering the risks of the investment. A combination of some or all these methods was reported in the appraisal and allowed the appraiser to identify a reasonable fair market value for the asset or project.
Of course, investors and developers are o en looking to determine the anticipated return from a real estate project rather than its value. If this is the goal, Cap Rates have little, if any, probative value. The two most frequently used metrics are Multiple on Invested Capital (“MOIC”) and Internal Rate of Return (“IRR”).
While each could be the subject of its own article, let’s take a very abbreviated look at both. Regardless of which approach is taken, an investor rst needs to develop a cash- ow model in line with the yield capitalization method discussed above. However, the model will di er in one extremely important respect: it must include the amount, the cost, and other terms of any debt that will be used in connection with the transaction as well as calculate the cash ows a er interest expense and amortization.
This can be relatively https://www.thesisdriven.com/p/understanding-cap-rates 10/13 easy in connection with the acquisition of a stabilized asset involving a single permanent loan or much more complex and uncertain if the transaction includes construction nancing that will need to be re nanced with permanent nancing at stabilization or perhaps a bridge loan at the end of construction to take the project through stabilization. MOIC has very straightforward appeal. If we invest $10 million in a real estate project and expect to receive $22 million back, we are anticipating receiving 2.2x the initial outlay.
It’s easy to compare to a di erent transaction projecting a return of 1.8x or 2.7x. Of course, the problem with the MOIC is that it doesn’t take account of when that return is realized. It is hopefully obvious that receiving a 2.2x return a er four years is far better than receiving a 2.7x return a er eight years.
This di erence goes by the term “time value of money” and is taught in any introductory nance course. IRR seeks to overcome MOIC’s shortcomings by taking account of when cash ows are received. We will skip the technical details here and just say that the IRR is intended to give a number that represents the annualized percentage return on the investment.
So, for example, there can be a projected IRR of 15, 20 or 25%. Higher is obviously better. One technical point is worth making—one that is not generally appreciated even by analysts that work with IRR all the time.
The IRR function assumes that cash ows received during the term of an investment are reinvested until maturity at the calculated IRR. This is o en not a fair assumption and needs to be kept in mind when thinking about actual returns that will be realized. The smaller the interim distributions the more accurate the calculated IRR will be.
For those of you familiar with bonds, think zero- coupon bonds. It is not surprising that as investors we search for simpli ed formulas to help us understand more complex ideas. The search for heuristics seems universal.
Moreover, real estate valuation using NOI, market values, and Cap Rates has the real advantage of focusing on variables that are directly observable and easily manipulable. That allows us to simplify the process of valuation as well as process large amounts of market data producing cross-sectional and time series charts that can provide useful insights and comparisons. https://www.thesisdriven.com/p/understanding-cap-rates 11/13 However, accurate valuation of speci c properties cannot be achieved by the application of simplistic rules of thumb.
The fundamentals are not di cult to understand. Current value re ects cash ows to be realized in the future. While the future is impossible to see and o en just as di cult to predict, intelligent valuation requires that we use our best estimates while simultaneously recognizing the limits of our abilities.
–Simon Jawitz Aspiring real estate operators looking to dive deeper into the world of cap rates and real estate nance should consider Thesis Driven’s Fundamentals of Commercial Real Estate course. We o er it every few months in New York City; the next one is on August 7-8th. https://www.thesisdriven.com/p/understanding-cap-rates 12/13