The Capitalization or “Cap” Rate is one of many tools that an investor uses to value a commercial real estate property. The formula for calculating it is relatively simple, but the intuition behind it is much more complex.

## Calculating the Cap Rate

The Cap Rate is calculated as the property’s projected year one Net Operating Income divided by its purchase price. Mathematically, the formula looks like this:

Net Operating Income is calculated as property income less expenses and the purchase price is the contemplated offer price. For example, if a property has a projected year one net operating income of $100,000 and a sales price of $1,000,000, the implied cap rate is 10%.

If the purchase price is unknown, the Cap Rate formula can be rearranged to perform a back of the envelope calculation for it. Here is what the formula would look like:

Instead of calculating it, the cap rate is determined by taking a market average for comparable properties. For example, if a property has NOI of $100,000 and the cap rate is 7% for comparable properties, the implied purchase price estimate is $1.42 million.

Again, the Cap Rate formula itself is simple, but the intuition behind it is complex.

## The Intuition Behind Cap Rate

The key concept behind the cap rate is the idea that a commercial property could theoretically produce a stream of income that runs in perpetuity (forever). Thus, it should be valued similarly to a “perpetuity.” The formula used to value a perpetuity is nearly identical to the cap rate formula:

Annual Income is similar to property NOI and the expected rate of return is an estimate of the annual return on the property. To illustrate this point, assume that a property produces annual income of $100,000 and the expected rate of return (annually) is 8%. The perpetual value of this stream is $1.25 million. And, like the cap rate, the formula can be rearranged to find the expected rate of return if the value is known. If the price was $1.3 million and we know that the investment would produce $100,000 in income annually, the implied annual return is 7.7%.

The key difference between the cap rate formula and the perpetual value formula is that, in a commercial real estate property, the annual income stream is likely to change over time as tenants renew their leases and lease rates go up or down. Thus, the cap rate is driven by two variables: (1) the expected return; and (2) the growth rate of the property’s income. Both of these variables are forward looking and rely on the best estimates of the purchaser at the time of evaluation. As such, they can vary from one investor to another.

## Expected Returns

The expected return, also referred to as the required rate of return, is defined as the rate that an investor would expect to earn from an investment. Like other asset classes, the expected return from a property is directly related to the perceived risk associated with purchasing it. A relatively safe property with a single credit tenant on a 30 year lease has less perceived risk than a functionally obsolete office building that is 40% occupied. As a result, the required rate of return for the single tenant property would be lower than the office building.

What makes the expected return tricky to estimate is that it is: (1) relative; and (2) constantly changing. We consider it to be relative because we evaluate it terms of its relationship with the interest rate on a 10-year Treasury Bond, which is sometimes referred to as the “risk free” rate. Here’s the logic: Treasury Bonds are backed by the full faith and credit of the United States government and the compensation for risk is always going to be relative to the rate on the 10-year Treasury Bond. For example, if the 10-year treasury rate was 5.00% and the expected return on the 40% occupied office building is 4%, we wouldn’t consider a purchase because there is no compensation premium for taking the additional risk. But, if the treasury was paying 5% and the property had an expected return of 10%, the deal may be more interesting because we’re being paid for the risk of the building relative to the treasury bill.

As the treasury rate changes, expected return values follow suit, which has a material impact on the price an investor may be willing to pay for a property. However, we know that a property’s income stream is not constant. It tends to increase over time, which is why the income growth rate is also a consideration.

## Income Growth

One of the major advantages to owning commercial real estate is that rental income tends to grow over time. In commercial properties, it is common for a lease to mandate annual “rent bumps” of 1% to 3%. In strong markets, high demand can drive rental rates to grow even faster.

Income growth – or the expectation of it – is one of the most important data points to evaluate when analyzing cap rates because it drives material changes in property value. For example, a property with year one NOI of $100,000 and a cap rate of 8% has a value of $1.25 million. If the income grows by 5% to $105,000 in year two and the cap rate stays the same, the property value is now $1.31 million.

To further illustrate this point, let’s assume that an investor is going to hold this same property for five years and that the NOI continues to grow by 5% annually while the cap rate stays the same. By the end of the holding period, the property will be worth significantly more than at the beginning and the investor will have earned a return from both the increasing income *and* the growth in property value.

In the example, the investor paid $1.25 million for the property and held the investment for five years. Because NOI grew by 5% each year, the “terminal value” or sales price is $1.64 million, assuming the same 8% cap rate. Given the actual income growth, the investor in this example has earned a strong profit.

## Other Factors Driving Cap Rates

In addition to required rates of return and expected or actual growth rates in income, there are several other factors that may influence a property’s cap rate.

Changes in return and growth expectations can drive market cyclicality. When rental rates are growing and demand is high, the expectations for future growth are optimistic, leading to higher prices. Conversely, when rental rates are stagnant or falling and the expectation for growth is pessimistic, the required rate is higher and property prices are lower.

The financial strength of tenants, or their credit, drives cap rates to the extent that it drives certainty around lease payments. Tenants with significant financial strength represent a low risk for default on their leases and an investor would pay a higher price/lower cap rate for the relative security of a strong tenant. For tenants with marginal financial strength, an investor would demand a higher rate of return, leading to a lower price.

Finally, remaining lease duration can affect cap rates due its ability to impact certainty of future cash flow. A property with several tenants whose leases are close to expiring is more likely to experience income variability upon lease renewal than one with tenants whose have many years remaining until expiration.

## Reducing Cap Rate Risk

We know for sure that cap rates drive property value, but the truth is, there is no way of knowing what they are going to be in the future when contemplating a real estate investment. To protect against changes in cap rates, there are two things that can be done to reduce the risk associated with movement.

The first is to increase income, which can be achieved by either improving the property to justify higher rents or by just charging higher rents. Often, a fresh coat of paint, new carpet, lighting, landscaping, or refreshed common areas will increase an owner’s ability to charge more. On the same base of expenses, NOI – and thus property value – will improve.

The other way to mitigate cap rate risk is to be conservative when underwriting the property prior to purchase. Many investors will incorporate overly optimistic assumptions about the direction of cap rates over the term of ownership. At a minimum, the “exit cap” rate should be the same as the “entry” cap rate if not a little bit higher. If an investor is able to achieve their required returns under these conservative assumptions, they’ll be rewarded with a stronger than expected return in a favorable market.

## Interested in Learning More?

Although important, cap rate analysis shouldn’t be done in isolation. We use it as one of many tools in our chest to analyze the risk/return profile of a potential investment.

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.