The ratio of a property’s first-year Net Operating Income (NOI) to its purchase price is called a capitalization (cap) rate. For instance, an asset with a NOI of $80,000 and a purchase price of $1,000,000 has a capitalization rate of 8% ($80,000 divided by $1,000,000).
This capitalization rate calculation may also be used reverse to determine a property’s market value. If a property’s yearly NOI is $60,000 and the market cap rate for properties with comparable features is 6%, then the property is worth $1 million ($60,000 divided by 0.06). When accurately valuing real estate, it is crucial to understand how the cap rate is determined and its limitations, even though this is a straightforward concept.
Why is the cap rate formula effective for valuing properties? The cap rate calculation to determine value is similar to the procedure used in finance to determine the value of an in-perpetuity investment (an income stream that runs forever). The equation is:
Value Enduring = Annual Income / Anticipated Rate of Return
A perpetuity’s value is calculated by dividing the annual income by the expected return. For instance, an investor who anticipates earning 4 percent on a $1,000 yearly income stream would be ready to spend $25,000 ($1,000 divided by.04). We may also invert the equation to get the anticipated rate of return for a given price. The estimated rate of return is 3.33 percent ($1,000 divided by $30,000) if the perpetuity is sold for $30,000.
Using a cap rate to value a property is identical since, in principle, property cash flows continue forever. NOI would replace the yearly income (numerator), and the cap rate would replace the projected return (denominator) in the preceding calculation (denominator). If a property is anticipated to generate $25,000 in annual NOI and market cap rates are 8%, the property would be valued at $312,500 ($25,000 divided by 0.08)
Because we are dealing with variable cash flows and a physical object, the cap rate is a little more complicated than in this case. Cap rates are a mix of two factors, projected returns and income growth rate, which we will examine in detail below.
Capitalization Rate = Anticipated Returns – Income Growth Rate
Expected Profits
The anticipated return, also known as the necessary rate of return, is the rate of return an investor anticipates receiving throughout the investment’s holding term. The more the risk associated with an investment, the greater the expected rate of return. The volatility and unpredictability of a revenue stream affect anticipated returns, which explains why stocks have a greater expected return than bonds and why an investor in a ground-up construction apartment complex would anticipate a more significant return than one acquiring a stable apartment complex.
The availability of other investment alternatives and long-term bonds, the ‘risk-free’ investment option, influence expected returns over time. If an investor can earn 4% on a 10-year Treasury bond, they would undoubtedly anticipate a greater return from riskier investments. Investors who obtain a 10 percent return from a stable apartment complex may expect a higher return from a hotel construction.
What Occurs When Returns Anticipate Change?
The value of the perpetuity will reduce to $20,000 ($1,000 divided by 0.05) if the necessary rate of return climbs from 4 percent to 5 percent during the holding term. Due to the fixed revenue streams, the only option for a new investor to get a better rate of return is to pay less.
Reverse outcomes are also possible when necessary, rates of return drop. If the predicted return falls from 4 percent to 3 percent, the perpetuity’s value will climb to over $33,000. (1,000 divided by .03). This is precisely what happens to property prices as cap rates decline. But a cap rate is more than simply the predicted return of the investment. It is a mix of the expected recovery, and the growth of NOI in the future since cash flows from real estate tend to rise with time.
Income Rate of Growth
Increasing NOI is one of the most significant benefits of real estate ownership. Typically, lease rates rise with time, providing property owners an increasing revenue stream. A lease between the lessee and lessor stipulates a contractual rent increase.
Typically, annual rent increases range between 1 and 3 percent. Any year, market rent increase may swing between -5% and 10% in a particular area but usually averages between 2% and 4% in regions with substantial employment and population development. The market rent growth is determined by comparing the rental rates of freshly signed leases from one year to the next.
Changes in growth assumptions may create significant fluctuations in a property’s value, making NOI growth likely the most crucial factor to consider when examining cap rates. In this instance, evolution refers to the anticipated future revenue increase. Past change is relevant to the degree that it influences people’s opinions of future development.
Here is the formula for valuing perpetual growth:
Perpetuity Value = Annual Dividend / (Expected Rate of Return – Future NOI Growth Rate)
Continuing with the scenario of perpetuity from above, suppose the investor still intends to earn 4 percent annually, but this time the $1,000 yearly cash flow stream rises by 2 percent annually. Due to the annual 2 percent growth rate of the income stream, the investor would now be ready to pay $50,000 for the same $1,000 perpetual income stream [$1,000 divided by (.04 minus.02)]. In this instance, a 2% growth rate doubles the price an investor would be ready to pay for perpetuity, even though the first year’s revenue remains same.
Most real estate investors do not own properties permanently and want cash flow and appreciation returns. One of the primary reasons real estate appreciates is because the revenue stream is more significant after the holding term than when the buyer purchased the property. The illustration below depicts what it might look like to retain a property with an increasing revenue stream for five years:
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
| Dividend Yield | $1,000 | $1,020 | $1,040 | $1,061 | $1,082 | $1,104 | |
| Final Value | $55,204 | ||||||
| Combined Cash Flow | -$50,000 | $1,000 | $1,020 | $1,040 | $1,061 | $56,286 |
In this instance, the investor contributed $50,000 and maintained the investment for five years. The value of the perpetuity at the time of sale, $55,204, is derived by dividing the year six cash flow by the predicted rate of return of 4 percent minus the future growth rate of NOI of 2 percent [$1,104 divided by (.04 minus.02)].
A cap rate is a combination of an investor’s expected return and the expected growth rate of NOI, which explains why a property with an 11 percent cap rate and an income stream expected to decline by 3 percent annually will generate the same returns as a property with a 5 percent cap rate and an income stream expected to grow by 3 percent annually.
11 percent Cap Rate: $25,000 / (.08+.03) = $227,272
5 percent Cap Rate: $25,000 / (.08-.03) = $500,000
In this example, both investors join the investment with the expectation of earning an annualized return of 8%, but they do it differently. Investors purchasing the property with a capitalization rate of 11 percent would receive their total return from cash flow and actually lose principal value, whereas investors purchasing the property with a capitalization rate of 5 percent would accept their return from both cash flow and appreciation.
Economic Cycles
Much of the cyclicality of the real estate market is attributable to variations in projected returns, NOI growth forecasts, and actual NOI. In a sector where property values increase, net operating income (NOI) growth is strong, and past achievements encourage hope for future development. A big numerator (NOI) and a small denominator (Cap Rates) yield pricey property values in the value equation.
As the economy slows, net operating income (NOI) decreases, and purchasers reduce their growth forecasts, resulting in a smaller numerator and bigger denominator in the valuation calculation. After the 2008 crisis, cap rates increased due to credit risk, which raised projected returns and a bleak forecast for NOI growth.
Rising cap rates and falling NOI have produced a scenario of excellent value destruction and one of the best purchasing opportunities of the last two decades. Real growth far outpaced expectations in the following decade, and credit risk declined.
Additional Factors
Other factors affect property cap rates, including lease tenure, discounts to replacement cost, region, and credit. Longer lease terms often attract lower capitalization rates since unbroken cash flows behave more like a long-term bond.
With better credit, tenants will have lower capitalization rates, as will properties with solid entry barriers selling at or below replacement cost. In both instances, the revenue stream is anticipated to increase throughout the holding term. In contrast, properties with above-market rents valued much beyond replacement cost are likely to fetch higher capitalization rates since it will be difficult to reproduce the cash flow after the lease ends.
In addition, cap rates are effective for stable properties with long-term leases but fail when revenue sources are variable. A building with a 50 percent occupancy rate and no revenue may have a far higher return potential than one with a 15 percent cap rate and a significant expiration tenant.
Lastly, a property with below-market rents is likely to sell at a lower capitalization rate than the market rate since its revenue will grow significantly at the expiry of the leases. The converse is true for properties with above-market rentals, whose leases eventually revert to market prices.
Mitigating Cap Rate Risk
There is no way to foretell with certainty where cap rates will be in the future, but every real estate investment has the risk that they will be higher when you sell than when you buy. This risk is mitigated in two ways: first, we add value to every property we acquire to grow NOI by more than 25 percent throughout our hold period; and second, when we underwrite a new deal, we drift cap rates higher during our hold period.
Increasing cap rates over the holding term are seen as an underwriting best practice and a means of incorporating downside protection. For instance, if the current market cap rate for stabilized properties is 5%, we would use a cap rate between 5.5% and 6%, depending on our hold time, to establish our terminal value. Be wary of any real estate investments whose terminal value is calculated using cap rates at or below current levels.
Accurately valuing a property is vital for successful investment, which begins with making the appropriate purchases. Understanding how a cap rate works when to utilize it and its restrictions may save investors a great deal of time and money.
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