What You Should Know About Cap Rates When Investing in Real Estate
A capitalization (cap) rate is the ratio of a property’s Net Operating Income (NOI) in the first year of ownership, divided by its purchase price. For example, an asset with an NOI of $80,000 that costs $1 million has an 8% cap rate ($80,000 divided by $1,000,000). This cap rate formula can also be used in reverse to find a property’s market value. If a property has an annual NOI of $60,000 and market cap rates are 6% for properties with similar characteristics, then the value of the property would be $1 million ($60,000 divided by .06). While this is a fairly simple definition, it’s important to also understand how a cap rate is derived and its limitations in valuing real estate accurately.
Why does the cap rate formula work to value properties? The cap rate formula to derive value is nearly identical to the formula used in finance to value a perpetuity (an income stream that runs forever). The formula is:
Perpetuity Value = Annual Income / Expected Rate of Return
The value of a perpetuity is found by taking the annual income and dividing it by the expected return. For example, if an investor expects to make 4% on an annual income stream of $1,000, the investor would be willing to pay $25,000 ($1,000 divided by .04). We can also reverse the equation to determine the expected return at a given price. If the perpetuity is being offered at $30,000, then the expected return is 3.33% ($1,000 divided by $30,000).
Valuing a property using a cap rate works in the exact same manner because, in theory, property cash flows extend forever. In the formula above, NOI would replace the annual income (numerator) and the cap rate would replace the expected return (denominator). If a property is expected to produce $25,000 of NOI each year and market cap rates are 8%, then the property would be valued at $312,500 ($25,000 divided by .08).
A cap rate is actually a bit more complex than this example because we are dealing with fluctuating cash flows and a physical asset. Cap rates are actually a combination of two variables, expected returns and the growth rate of income, both of which we explore in great depth below.
Capitalization Rate = Expected Returns – Growth Rate of Income
Expected Returns
The expected return, also called the required rate of return, is the return the investor would expect to receive during the investment hold period. The higher the risk of an investment, the higher rate of return an investor would expect to achieve. Expected returns are driven by an income stream’s volatility and uncertainty, which is why stocks have a higher expected return than bonds and why an investor in a ground-up development apartment complex would expect to generate a higher return than an investor acquiring a fully stabilized apartment complex.
Expected returns change over time and are impacted by both the availability of alternative investment options and long-term bonds, the ‘risk-free’ investment option. If an investor can generate 4% from a 10-year treasury bond, then they will certainly expect a higher return from riskier assets. If an investor can achieve a 10% return from a stabilized apartment complex, the return they would expect to achieve in a hotel development would be far greater.
What Happens When Expected Returns Change?
Building on the perpetuity example above, if the required rate of return increases from 4% to 5% during the hold period, the value of the perpetuity will decrease to $20,000 ($1,000 divided by .05). Because the income streams are fixed, the only way for a new investor to get a higher rate of return is to pay a lower price.
The opposite can also happen when required rates of return decline. If the expected return declines from 4% to 3%, then the value of the perpetuity would increase to more than $33,000 (1,000 divided by .03). This is exactly what happens to real estate values as cap rates go lower. But a cap rate is more than just the investor’s expected return. It is a combination of both the expected return and the future growth of NOI, as real estate cash flows tend to increase over time.
Growth Rate of Income
NOI growth is one of the best features of owning real estate. Lease rates typically increase over time, providing owners with a growing income stream. Contractual rent growth is an agreement between lessee and lessor and codified in a lease. Annual rent escalations are typically between 1% and 3%. Market rent growth varies and can fluctuate between -5% and +10% in a market in any given year, but typically averages between 2% and 4% in markets with robust jobs and population growth. Market rent growth is calculated by looking at the rental rates of newly signed leases on a year over year basis.
Growth of NOI is arguably the most important variable to consider when looking at cap rates because changes in growth assumptions can cause massive swings in a property’s value. In this case, growth refers to the expected future growth of income. Past growth matters only to the extent that it impacts people’s perceptions of future growth.
Here is the formula to value a growing perpetuity:
Perpetuity Value = Annual Dividend / (Expected Rate of Return – Future Growth Rate of NOI)
Building on the perpetuity example from above, let’s assume that the investor still desires to make 4% per year, but this time the $1,000 annual cash flow stream grows by 2% each year. The investor would now be willing to pay $50,000 for that same $1,000 perpetuity because of the annual 2% growth rate in the income stream [$1000 divided by (.04 minus .02)]. In this case, a 2% growth rate doubles the price an investor would be willing to pay for the perpetuity, even though the year one income is identical.
Most real estate investors don’t hold properties forever and look to achieve their return from both cash flow and value appreciation. One of the main reasons real estate appreciates is because the income stream is larger at the end of the hold period than when the buyer acquired the property. The following example below illustrates what it would look like to hold the perpetuity, or a property, with a growing income stream for five years:
Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
---|---|---|---|---|---|---|---|
Annual Dividend | $1,000 | $1,020 | $1,040 | $1,061 | $1,082 | $1,104 | |
Terminal Value | $55,204 | ||||||
Total Cash Flow | -$50,000 | $1,000 | $1,020 | $1,040 | $1,061 | $56,286 |
In this case, the investor paid $50,000 and held the investment until year five. The value of the perpetuity at sale, $55,204, is calculated by taking the year six cash flow and dividing it by the 4% expected rate of return, minus the 2% future growth rate of NOI [$1,104 divided by (.04 minus .02)].
As you can see, a cap rate is actually a combination of both an investor’s expected return and the expected growth rate of NOI, which explains why a property with an 11% cap rate and an income stream expected to decline by 3% each year will generate the same returns as a property with a 5% cap rate and an income stream expected to grow at 3% per year.
11% Cap Rate: $25,000 / (.08+.03) = $227,272
5% Cap Rate: $25,000 / (.08-.03) = $500,000
In this example, both investors would enter into the investment expecting to achieve an annualized return of 8%, but they get there in very different ways. Investors buying the property valued at an 11% cap rate would be receiving their entire return through cash flow and would actually lose principal value, while the investor buying the property at a 5% cap rate would achieve their return through both cash flow and appreciation.
Market Cycles
Much of the real estate market’s cyclicality is a result of changes in expected returns, NOI growth expectations and actual NOI. In a market where property values are increasing, NOI growth is robust and past growth tends to lead to optimistic views of growth going forward. A large numerator (NOI) and a small denominator (Cap Rates) in the value equation combine to create expensive property values. As the economy slows down, NOI declines and buyers dial back their growth assumptions, resulting in a smaller numerator and larger denominator in the valuation formula. The years following the 2008 recession witnessed cap rate expansion due to both credit risk, driving expected returns higher, and a dim outlook for NOI growth. Rising cap rates and depressed NOI created a situation of unprecedented value destruction but also one of the greatest buying opportunities in the last 20 years. Over the ensuing decade, actual growth exceeded expected growth by a large margin and credit risk diminished.
Other Considerations
Property cap rates are also impacted by other variables such as lease duration, discounts to replacement cost, geography, and credit. Longer lease durations generally command lower cap rates because uninterrupted cash flows tend to behave more like a long-term bond. Tenants with higher credit quality will drive cap rates lower, as will properties with high barriers to entry selling at or below replacement cost. In both cases, the income stream is likely to experience a level of growth during the hold period. Conversely, properties with above market rents valued far in excess of replacement cost are likely to command higher cap rates, as the cash flow would be difficult to replicate when the lease expires.
Additionally, cap rates work well for stabilized buildings with long duration leases, but the methodology breaks down when income streams encounter variability. A building that is 50% occupied with no income may have far more return potential than a building that is for sale at a 15% cap rate with a large expiring tenant. Finally, a property with below market rents would be likely to trade at a cap rate lower than the market rate as that income will increase substantially upon the expiration of the leases. The opposite is true of properties with above market rents as those leases roll down to market levels.
Mitigating Cap Rate Risk
There is no way to know for certain where cap rates are going to be in the future but the risk to any real estate investment is that they are higher when you sell than when you buy. We counter this risk in two ways: First, we add value to every property we acquire with the intention of growing NOI by more than 25% during our hold period and, second, we drift cap rates higher throughout our hold period when we underwrite a new deal. Increasing cap rates throughout the hold period is considered best practices in underwriting and a way we build in downside protection. For example, if market cap rates for stabilized properties are 5% today, then we use between a 5.5% and a 6% cap rate, depending on our hold period, to determine our terminal value. Beware of any real estate investments that calculate terminal value using cap rates at or below today’s rates.
Origin invests in America’s fastest-growing markets because we understand how important it is in creating value. Investors should look for growth potential in any income stream, whether it be in stocks, bonds or real estate. Keep in mind that cap rates cannot be used in isolation to value a property or to understand an investment’s potential. The cap rate is one of many tools we use at Origin when evaluating a property’s potential. Successful investing starts with buying right and knowing how to value a property accurately is essential. As an investor, understanding how a cap rate works, when to use it, and its limitations can save a lot of time and money.