I’ll tell you right now that cap rates are one of the most commonly used terms in real estate and one of the most misunderstood. Even though it’s widely used, I’m constantly surprised by how little people understand cap rates. If you ask ten brokers, “what is a cap rate?” they might give you a general understanding. However, if you ask them to explain how it is determined and what factors go into calculating a cap rate, you will get a variety of responses.
It is common in real estate that the terminology employed has a general market understanding but is often perceived differently by different persons. There is no centralized Real Estate School. There may be clear definitions of a notion somewhere, but there is no necessity for everyone to read and learn such concepts or definitions.
As a result, most real estate concepts are understood via the lens of human experience and who taught them or how they came to learn what the notion meant.
There is very little consistency, and I would recommend you to ask a sponsor what they mean by a term if you’re not sure what it means. In some circumstances, you may find the answer illuminating.
Background Knowledge on Cap Rates
One of the intriguing elements of having that awareness is that if someone does not truly understand what a cap rate entails, it might lead to errors.
Errors can be taken advantage of. A sponsor may find a deal in which the seller gave the wrong cap rate and used the one that the seller thought was typical for the market.
So, assuming that the cap rate was market, I sold a property at a given cap rate and at a certain price based on the ratio that equals the cap rate. They might have underpriced the asset if they made a mistake.
Because the seller underestimated the cap rate or anything else, the buyer, the sponsor in which you are investing, may have gotten a deal. As a result, it can uncover hidden value that the seller was unaware of because the seller did not fully grasp the notion of correctly pricing the property.
What Exactly Is a Cap Rate?
In this example, the bank provides you 1% in exchange for your $100. They’re offering you $1 for every $100 you deposit. Cap rates are similar to the interest gained on your money but with key differences. It is not the same as the rate of return on your investment. The cap rate is related to something else, yet it is similar to the interest on money.
A cap rate is useful as an equalizer because it is a statistic employed in all real estate investments. It is something that you can use, as long as it is employed consistently throughout all deals that you look at, to compare the types of returns that they will offer you. It will assist you in deciding what to invest in and what not to invest in by allowing you to compare deals.
It is not the defining distinction between all types of development. Still, it is a significant factor in establishing a comparison.
How Does a Cap Rate Function?
What does this mean for pricing? There is a symbiotic link. The higher the price, the lower the cap rate.
Let us return to our banking scenario. And let’s imagine we’re going to deposit $100 and get a 1% return. To earn one dollar, you must spend $100 on a bargain. This is equivalent to a 1 cap investment.
Assume it reaches a 5 cap. The bank is now providing you with 5% interest. To earn $1 at 5%, you must deposit $20 into a bank account. So, a higher cap rate equals a lower property price in terms of business or real estate.
Assume you want $1 million in annual income, and the market has a 5 cap. To obtain that $1 million, you would need to spend $20 million.
The premise is that if the market were a 1 cap, a far lower cap rate, you would have to invest $100 million to make that million dollars per year.
As a result, as a crowdfund real estate investor, you can spread your investments across several asset classes to blend profits and limit risk. As a result, you can invest in either higher cap rate asset classes and regions or lower cap rate asset classes and locations. It’s a tool that can help you keep your portfolio in good shape.
Buildings in the mid-millions may be seen in one market. Choosing apartments, for example, is a simple task. How do you compare apartments in the mid-millions to those in the millions? Is one 5 times as much as the other? Rents are likely to be higher, and the only way to truly evaluate it is through the relationship between income, what people spend on housing and the cost of purchasing in those markets.
One thing to consider is the cap rate. This will level the playing field and allow you to compare different markets. Using cap rates also allows you to deploy investment strategies that contrast purchasing low cap rate assets in high cap rate markets to purchasing high cap rate assets in low cap rate markets. Alternatively, in plain English, this means buying expensive properties in less expensive places.
Expensive vs. Inexpensive Real Estate Properties
Which is preferable: purchasing an expensive house in a cheap region or a cheap property in an expensive location? Actually, I had a very interesting talk with Dr. Greg McKinnon of the Pension Real Estate Association (PREA).
He is an academic and economist at the association who conducted extensive research over a long period. He investigated whether it is better to invest in high cap versus low cap neighborhoods and low cap versus high cap structures.
He concluded that investing in higher return properties in less expensive places is preferable to investing in lower return properties in more expensive areas.
As previously stated, the cap rate is a straightforward concept that is sometimes misunderstood. I’ll lead you through some different views so you can gain a better understanding of what it means by approaching it from other sides.
Debt and Cap Rates
The only way to calculate the cap rate is to compare it to the building’s unlevered cost. There is no debt allowed in your cap rate calculation, whether it be the cost of developing it or the cost of purchasing it versus the predicted net operating income or the actual net operating income.
By employing the “assume all cash” approach and removing debt from the cap rate notion, you can truly compare apples to apples.
What Is a Reasonable Cap Rate or Net Operating Income for An Investment Property?
Another approach to consider the cap rate is as a multiple of the NOI. For example, suppose you find a building on the market with an NOI of $50,000 and decide to buy it for $1 million. What you did was pay 20 times the building’s net operating income. That is, for every dollar of net operating income added, the building’s worth increases by 20 times the amount of NOI added, correct?
Here’s another one. Assume you own a ten-unit apartment complex where each unit pays $1,000 monthly rent. That equates to $120,000 in gross income.
So you take the gross income and subtract the costs, assuming 30% of the costs. So your net operating income, or NOI, is $120,000 – $36,000. As a result, your net operating income is $84,000.
The sponsor is now raising the rents by $100 for each unit. Assume that the extra money goes straight to the bottom line, implying that the price increase has no further costs.
Your NOI, or net operating income, has now increased by $100 each month multiplied by 10 units over a 12-month period. Your NOI increased by $12,000. So, how does this affect property value? The property’s value has risen from $1.68 million to $1.92 million. The value climbed by over a quarter-million dollars just because the sponsor raised the rents by $100 for each unit.
That’s a great approach to look at the increased value. And many of the bargains you see on crowdfunding sites use the same idea to provide value.
Methods for Increasing NOI
What are the different ways a sponsor can raise rents? One possibility is to ask respectfully. You just never know. A more likely solution would be to upgrade the units. You could also evict tenants if morals, ethics, and laws allow it. In many circumstances, it’s just business.
Other choices include installing recessed lighting, adding more illumination to a unit, brightening up the lobby area to add a sense of elegance or appeal, and improving the landscape area. These are the kinds of bargains you’ll find on a lot of crowdfunded websites.
Assuming that all that work costs the sponsor $10,000 per unit, for a total of $100,000, and the building increases in value by $240,000, raising rents may be worthwhile.
“Build to” Cap Rates
Build to cap rates is a little more complex idea. The build-to-cap-rate example can be used to determine whether a deal is a good idea. You have a sponsor who wants to pay $3 million for a plot of land to develop apartments. It will cost him $17 million. The entire cost of the project that he is considering is $20 million.
In Scenario 1, he will have a building that generates $1 million in NOI after completing and stabilizing the structure. That indicates that if the market in that location were a 5, his building would be worth $20 million with a $1 million NOI.
Obviously, you don’t want to create and then lose money, as this scenario would. In this scenario, the sponsor is aiming for a 5 cap. It’s also pointless to construct a 5 cap if the market rate for properties in the region is also a 5 cap. There is no upside to using a build-to-cap rate. You’re not going to get rich. It isn’t worth it.
After changing the NOI stability to $1.4 million, the sponsor is working toward a 7 cap. Cap rates are computed as 1.4 million divided by building cost = 7%, correct? If the market in this location is ready to pay a 5 cap, the finished worth of the building will be 1.4 million divided by 5 times 100. So 28 million people. He built to a 7 cap, but the market is a 5; thus the worth is 28 million. As a result, this might be a “go” scenario. The 2% gap between the build to cap and market cap makes this deal appear to be a “go” deal.
Cap Rate Terminology You Should Know
I’m going to tell you a few more terminology you might hear in the field from sponsors talking, as well as the types of language they might use.
In the same case, the sponsor has grown to a 7 cap in a 5 cap market. We now have a 200-basis-point spread. “I’ll never do a deal until there’s a 200 basis point difference between market and ‘build to.'” They might also say “200 bips,” “200 BPS,” or “2 percent difference between cost and market value.” If there is a 200 bip disparity between market value and his build-to rate, he will begin to focus on those offers.
In 2020, what type of commercial property has the highest cap rate?
Because of the methodology used to compute cap rates, certain asset classes may have fundamentally greater or lower cap rates based only on their kind. This is true for every commercial real estate asset. Operational risks change dramatically from year to year as trends shift and tenant needs or preferences shift.
These asset types have some of the highest cap rates in 2020:
Medical office buildings are not the same as other types of office buildings. While they appear to be similar from the exterior, they differ in a few critical areas that affect cap rates:
- Tenant pools are smaller.
- Specific tenant specifications.
- Increased building operation costs.
Some of the primary benefits of medical office spaces can help to balance out these factors. Specifically, many tenants have good credit and extended lease terms. Furthermore, these tenants tend to extend their contracts due to the high switching costs associated with seeking new space. Building or remodeling an office space for medical institutions also requires a considerable upfront expenditure, resulting in decreased competitiveness in many places.
Historically, medical office buildings had far higher cap rates than ordinary office spaces. However, this has altered as cap rates for conventional office space have risen in recent years. This has resulted in lower cap rates for medical office buildings while still having higher cap rates overall.
Cap Rates for Multi-Family
Cap rates on multifamily properties have risen recently as tenant preferences move to more expensive structures. The higher cap rate is caused by higher operating expenses in these buildings, which are frequently in the form of additional common areas or amenities.
Co-living is becoming more popular in multifamily housing. These are buildings in which tenant units are little equipped, with the majority of features and facilities provided in communal areas shared by all tenants or clusters of units.
Buildings with more shared areas have higher operating costs. The higher the expenditures for maintaining and administering the building itself, the more facilities and spaces are provided outside rented flats.
Hotel Cap Rates
Rising labor expenses are having a considerable influence on hotel and comparable asset cap rates. These buildings not only contain enormous common areas and numerous public facilities, but they also require a large workforce to function properly. Bars, restaurants, game rooms, laundry facilities, swimming pools, and other social areas all need professors and general operating expenses to run smoothly.
For investors, hotels present a particular problem. Due to the hands-on character of the structures, investors must decide whether to operate as landlords or as businesses. Hotels and other high-maintenance real estate assets are companies in their own right, requiring investors to manage both the building and the firm at the same time. This raises the capitalization rate for hotel properties.
Cap Rates for Retail Stores
Retail establishments, like hotels, face the issue of high-maintenance tenants who necessitate a balance of landlord and business operations. Retail tenants are having problems maintaining their services, resulting in a higher rate of insolvency than other asset groups. Several high-profile bankruptcies in recent years have resulted in landlords bailing out their tenants in order to keep them operating in retail spaces – and the COVID issue is likely to intensify this tendency even further.
In this situation, coworking spaces are classified similarly to retail stores. Because individual tenant leases are not as long as the master tenant, the coworking operator, they tend to have higher cap rates. Leases in coworking spaces are typically on a cash basis with short contracts, which means there is little to no security of future income. As with retail locations, increasing landlord engagement in general operations and a high level of uncertainty about future income contribute to higher cap rates.
Cap Rate Variations
There are a few different cap rates. Apartments are frequently the most in-demand asset class, and as a result, they have the lowest cap rate. If you’re interested in flats, you’re probably going to spend more for the income stream that comes with them than you are for any other asset class. It is widely regarded as the most secure asset during a downturn.
That doesn’t mean you can’t overpay for an apartment. It is a safe asset class because it generates an income source. And, to provide an extreme example, it is the polar opposite of land. You may invest in land and get a terrific price on it. But, guess what happens when the market turns?
Land provides no income
In reality, that is the only cost. Insurance and property taxes must be paid. So, during a downturn, land will drain money out of you, whereas apartments will be full with tenants. Even though the tenants are paying less rent, the property still generates cash. Apartments are thought to be very attractive since they provide money.
However, you can lose money in real estate. Take what I say about it being a safe asset class with a grain of salt. Everything is relative.
One difficulty with apartments is that there is sometimes a lot of overbuilding, particularly in the premium end of the market. Sponsors must purchase land at increasing prices when land prices rise. As a result, to justify the underwriting, they must increase their expected rentals. They can only do this by developing more and more opulent residential buildings.
So, you discovered that there is a glut at the top end of the apartment market at the conclusion of a cycle, the end of a cycle’s upswing, and a dearth of product at the more inexpensive end of the market. For whatever reason, it is and has always been a very popular asset class.
What Influences a Cap Rate?
- Asset Location
In most of the United States, typical cap rates for similar types of buildings stay quite steady. This provides for a straightforward comparison. However, in some markets, particularly in boom economies, different levels of buildings might have drastically varying cap rates. It’s worth noting the difference in cap rates between multifamily and office space.
While large metros such as New York or Los Angeles may have moderate disparities in cap rates between these two asset classes, growth areas such as Austin or smaller metros such as Richmond, VA, may have a massive disparity. Multifamily properties typically have lower cap rates, whereas office buildings in similar regions typically have higher cap rates due to growth projections.
- Liquidity of Capital
The source of financing is nearly completely responsible for multifamily homes’ lower cap rates. Many business and residential assets, including multifamily structures, are eligible for Freddie Mac or Fannie Mae financing. These are government-backed loans with high liquidity, making them a lower risk overall.
- Market Size/Tenant Access
The size of the market is an important consideration in calculating the reasonable cap rate. Cap rates are often higher in areas with a small tenant pool to compensate for the risk of vacancy. Smaller markets cannot support as much growth as larger markets. There may be more rivalry to attract and maintain renters, which larger metro areas do not typically face.
Again, the exception is multifamily housing. Tenants for multifamily apartments are seen as commodities, resulting in lower cap rates even in smaller markets. Office buildings, retail establishments, medical real estate, and other types of specialty CRE often have higher cap rates in smaller cities.
- Growth Prospects
Cap rates in growth markets are often higher. Along with the cost of capital, this is one of the most important elements influencing cap rates. Low growth may result in lower cap rates, whereas high growth may result in higher cap rates. It’s a normal aspect of the real estate process.
- Stability of Assets
When markets experience a downturn, stable assets outperform volatile ones in the long run. Buildings with greater running expenses and smaller NOIs have higher cap rates to begin with, but building classes that are intrinsically volatile in a market downturn may see a quick jump in cap rates during the recession. Hotels and specific forms of retail real estate are two examples.
How Do Cap Rates Differ Between Cities and Suburbs?
The cap rate of any property is determined by a plethora of distinct criteria. The most critical set of characteristics, however, is the property’s location. Cap rates range significantly between large urban metro areas and smaller suburban places. Differences in cap rates in various sectors, however, do not necessarily imply that one is a better investment than another.
One of the most apparent variations between market types is the spread between cap rates in various asset classes. As previously stated, due to the commoditized nature of tenants and the greater availability of loans, multifamily tends to have lower cap rates across the board. Retail real estate, hotels, office buildings, medical real estate, and industrial real estate, on the other hand, vary greatly based on location.
The average cap rate trend for CRE (excluding multifamily) is greater in suburban locations and gradually decreases as population and market size increase. Although hotels, office buildings, and retail real estate can generate significant yields in suburban locations, they are also more vulnerable to market volatility.
Historically, larger urban metro areas have more consistent cap rates across all asset categories. However, as the tech industry has grown, an intriguing trend has emerged.
Many tech companies choose premises outside of urban areas to save money, but they also like to cluster with other tech workplaces. Technology, information, and media companies are progressively relocating to emerging regions rather than established urban centers, balancing the usual cap rates in these sectors.
Cap Rate Terminology You Should Know
In the industry, it is common to distinguish between cap rates from the past, those of the present, and those of the future. Let me unpack that for you a little bit. As a result, listing brochures for apartment buildings frequently discuss the difference between the building’s current cap rate and its market cap.
In the same case, the sponsor has grown to a 7 cap in a 5 cap market. We now have a 200-basis-point spread. “I’ll never do a deal until there’s a 200 basis point difference between market and ‘build to.'” They might also say “200 bips,” “200 BPS,” or “2 percent difference between cost and market value.” If there is a 200 bip disparity between market value and his build to rate, he will begin to focus on those offers.
Yesterday, Today, and Tomorrow
Cap rates from yesterday, today, and tomorrow are often compared. Let me unpack that for you a little bit. As a result, listing brochures for apartment buildings frequently discuss the difference between the building’s current cap rate and its market cap.
Although the building is being sold at a 5 cap, the market rates on current income are higher. As a result, you’re paying a 6 cap for it. So you’re getting a bargain. So, if you’re paying a 6 cap price for a 5 cap market, you’re getting a steal.
Similarly, sponsors may categorize returns based on forecasts rather than actual income. There is a substantial contrast between this concept and trailing versus forward-looking cap rates analyses. What does this structure now earn? What has it earned historically versus what you anticipate? This is among the most crucial components of the due diligence procedure.
The sponsor will forecast a comeback, but there will be no assurances. They’ll be projecting what they think they can obtain, which is why you have to be cautious. The only things you can be confident of are what occurred and how the building has previously operated. You have no idea how it will function in the future.
The sponsor is outlining their thesis on where they believe the value will go, but they don’t know for sure. You may come across sponsors who are certain that they have discovered a building with undiscovered worth.
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