Cap Rate vs. Return on Cost: Valuing Commercial Real Estate
Many investors ask us what capitalization rate (cap rate) we used to acquire a property. The question is simple but the answer is complicated because valuing real estate never comes down to a single metric. We’ve acquired properties with cap rates below zero and passed on others with cap rates above 15%.
What is a Cap Rate?
A cap rate is the rate of return you’d expect to receive from a property during the first year of ownership, excluding the cost to improve the property and financing costs. Think of a cap rate as the dividend one would receive in the first year if the property were acquired with all cash. The cap rate is calculated by taking the Net Operating Income (NOI), which is the property revenue, minus the necessary operating expenses, and dividing it by the purchase price. For example, if a property generates $500,000 of NOI in the first year of ownership and it sold for $8 million, the initial cap rate is 6.25% ($500,000 divided by $8,000,000).
A cap rate represents a snapshot in time. In some cases, the cap rate is a “trailing cap rate,” which represents the NOI generated at the property for the preceding 12-month period. In other cases, the cap rate is an “initial” or “going-in” cap rate, which reflects the forecasted NOI for the first 12 months of ownership. It’s important to clarify this, because the trailing cap rate could be very different than the initial cap rate. For example, if there’s a forecasted change to property revenues (such as an increase or decrease in occupancy or increasing rental rates due to renovations) or expenses (such as an increase or decrease in property taxes or changes to operating expenses), the cap rate won’t be an accurate gauge to determine value.
Cap rates are heavily influenced by the expected future growth of the underlying NOI, credit of the tenant, contractual length of the leases, and the liquidity available in that investment market. Assets located in primary coastal markets in the United States and other global centers like London, Tokyo and Sydney all have global investors clamoring to purchase the limited amount of assets that exist in those markets. As a result, they are all considered extremely liquid investment markets and the amount of investor demand places upward pressure on prices, resulting in lower cap rates. These markets also tend to have strong economic growth factors that make it possible for owners to increase their rents, relative to markets with weaker fundamentals. For example, with substantial market rent growth increases a property in New York with a 4% cap rate could increase yield to 6%-8% and appreciate significantly in value. Conversely, in markets like Toledo, Ohio, where liquidity and economic growth prospects are low, investors need to ensure that they receive more of their return from the yield as the chances for value appreciation are low, which may mean these assets selling at a 12% cap rate.
When to Use a Cap Rate
For stabilized properties with predictable income streams, the cap rate metric can serve as a helpful valuation tool and can be useful for benchmarking opportunities against one another. For example, a Walgreens property with a 30 year lease in Chicago will command a similar cap rate to a Walgreens in Miami, all other things held constant. The investor in this example is less concerned about the actual physical property than the creditworthiness of Walgreens and their ability to uphold the terms of the lease for the entire 30-year term. This investment is more like a bond, as the owner is buying a stable 30-year income stream, so the cap rates are generally lower (in the 5.0% – 6.0% range) and are almost solely based on the underlying credit quality of the tenant.
Cap Rate Limitations
For multi-tenant investments, especially opportunities where one is making a number of value-added improvements, the cap rate is somewhat irrelevant because of the instability of the underlying cash flows. For example, an office building that is 30% occupied may have a negative NOI as the revenues are insufficient to cover the operating expenses, thus resulting in a negative cap rate. However, this could prove to be an incredible opportunity if the owner stabilized the property through reinvestment. To value these types of opportunities, we use a different metric called Return on Cost.
What is Return on Cost?
Return on Cost is a forward-looking cap rate; it takes into consideration both the costs needed to stabilize the property and the future NOI once the property has been stabilized. It’s calculated by dividing the purchase price by the potential NOI. We use return on cost to determine if we’ll potentially generate an income stream greater than what we could achieve if we purchased a stabilized asset today.
For example, if fully-renovated, stabilized properties are trading for a 6% cap rate today, it would mean that for $20 million, we would achieve $1.2 million of NOI. If we acquired a value-added opportunity for $18 million that needs another $2 million in renovation capital, it would cost $20 million in total. Let’s assume the property has been mismanaged and is only 80% occupied with an NOI of $750,000. However, once the value-add business plan has been executed, in three years the property’s NOI has the potential to increase to $1.5 million. The return on cost for this property would be 7.5% ($1.5 million divided by $20 million). We now have $1.5 million of income and if we divide that by the stabilized cap rate of 6%, the property is now worth $25 million, generating substantial value creation relative to the purchase of the stabilized asset.
The cap rate is simply one of many lenses investors should use to evaluate a real estate investment. It’s imperative to know what the cap rate represents and its limitations in order to understand how to use it when valuing real estate. Most importantly, the cap rate should not replace the best method to value real estate: discounted cash flow analysis. Valuing real estate is complex and is both an art and a science; the best valuation methods use a combination of trailing and initial cap rates, assumptions for the cap rate upon sale to the next buyer, plus return on cost. Using cap rates in isolation can lead to poor outcomes.