Cap Rates: A Deep Dive

The “cap rate” is probably the most widely used metric in commercial real estate.  It’s a metric that I refer to almost every day when describing or evaluating an investment opportunity.  In short, a cap rate is the unlevered annualized rate of return of an investment.  In other words, a cap rate is the yield one would make on a given investment assuming that it was an all-cash purchase.

Recently I was in a meeting with a bunch of real estate guys and gals.  Some were analysts and some were executives with Ivy League MBA’s. We discussed and debated the theory behind discount rates which you can read about in this blog post (How to Select the Appropriate Discount Rate) and cap rates.  It ended up being an interesting conversation about how these two metrics are thought about both academically and in practice.  This post is on the role of cap rates in CRE.

The simple equation below indicates how a cap rate is calculated:

Cap Rate = NOI / Purchase Price

or

Purchase Price = NOI / Cap Rate

The cap rate formula is simple and straightforward way to evaluate the pricing of a given asset.  You take your net operating income and divide it by the purchase price, and you have the cap rate.  The formula can also be used to determine how much you would be willing to pay for an asset.  Let’s say you know the going rate for a particular asset is a 7-cap, then you can compare that to the subject cap rate to determine if it is priced relatively high or low. 

Quick cap rate example

Let’s say a property has an annual NOI of $100,000 and the market cap rate for this type of property is 5%.  This means that the value of the property is approximately $2,000,000 ($100,000 divided by 5% = $2,000,000).

High cap rate or low cap rate . . . Which is better?

A relatively low cap rate equals a relatively high purchase price.  Conversely, a relatively high cap rate means the purchase price is relatively low.  Therefore, buyers seek after high cap rates, and sellers desire low cap rates (high prices). Cap rates tend to be between 5-10% these days. At the time of this post (July 2019) cap rates are at or near historic lows. Take a look at the below graph to see where cap rates were toward the end of 2018..

What influences Cap Rates

Risk free rate
(10-year U.S. Treasury Bond)
Cap rates generally move with the risk free rate. But, changes to the cap rate tend to lag behind changes to the risk free rate
Availability of debt Greater availability of debt decreases cap rates as more buyers will compete to buy property
Health of real estate market Strong markets result in downward pressure on cap rates
Property type Riskier properties trade at higher cap rates
Rent roll (quality of tenants, lease terms, etc.) Tenant credit plays a large factor, particularly single-tenant assets
Location, trade area, site characteristics  

Gordon Growth Model: getting real nerdy

The Gordon Growth Model provides a more accurate and slightly more complex cap rate formula.  In my many years in this business, however, I’ve never heard someone refer to the Gordon Growth Model when describing the cap rate. So, on a practical level, you don’t need to know this.  However, it does provide some additional color as to how cap rates are determined and what factors influence them. If you’re a finance guy or gal, you’ve probably heard of the Gordon Growth Model.  And as you may already know, the model is used to determine the intrinsic value of a stock based on a series of dividends that grow at a constant rate. The formula is:

P = CF / k-g

Where: P = Price, k = discount rate; g = constant growth rate; and CF = cash flow

Real property can be valued using the same methodology.  When cap rates are broken down, it’s easy to see that they are determined by a combination of two variables: The discount rate and the growth rate of income.  When converting this to real estate terminology we produce the following equation:

Purchase Price = NOI / (Property Discount Rate – NOI Growth Rate)

Cap Rate = Discount Rate – Growth Rate of Income

We can use this formula in the following way.  Let’s say we have a building with annual NOI of $100,000 and we expect NOI to increase by 2% annually.  We can determine the cap rate by taking our discount rate and subtracting 2% (go back to my blog post on discount rates to understand how to determine the discount rate). For simplicity, let’s assume our discount rate is 10% because that is our required rate of return.  The cap rate would be 10% – 2% or 8%. Therefore, the value of the property is $1,250,000 [$100,000 / (10%-2%)].

When to use a Discounted Cash Flow Analysis instead of relying on the Cap Rate

Generally you can think of a cap rate as a back of the envelop metric used to quickly asses the potential yield of a real estate investment.  Therefore, sophisticated investors rely on a discounted cash flow analysis to take a deeper dive into the return characteristics of the investment.  You will always want to rely on DCF analysis when the property’s income stream is unstable.  If the property’s income stream will deviate significantly from one year to the next, you don’t want to make an investment decision based on the cap rate.  You’ll need to use DCF. Cap rates are particularly useful when evaluating single tenant net leased properties because they behave like bonds.

Income Multiple vs. Cap Rate

For those of you who have a background analyzing the value of businesses know that businesses trade at a multiple of the company’s earnings.  A cap rate is essentially the inverse of an income multiple (see my blog post where I compare real estate and business terminology).  To determine the multiple of a particular investment, divide 1 by the cap rate.  For example, if a property’s cap rate is 7%, the earnings multiple would be 14.3x (1/7% = 14.3x).

Greg Barrett
Greg Barrett
Greg Barrett is the founder and editor of CREentrepreneur.