** Note: be sure to see the bottom of this post, where we have links to another 10 posts on cap rates. **
A “cap rate” (short for capitalization rate) is simply a measurement of yield on an income-producing commercial real estate property (office, industrial, retail, multi-family, self-storage, hotel). The math behind the calculation of a cap rate is as simple as it gets. The cap rate formula is annual property net operating income / property purchase price.
Here’s an example of a cap rate calculation:
- Annual property net operating income (NOI) = $800,000
- Property purchase price = $10,000,000
- Cap rate = $800,000 / $10,000,000 = 8.00% (“an 8 cap”)
People generally talk about cap rates in the context of properties trading, such as:
- “123 Main Street traded at a 6 cap”
- “We sold 123 Main Street at a 6 cap”
- “We purchased 123 Main Street at a 6 cap”
- “Class A apartment properties are trading at a 6 cap”.
The good news is that if we know the price at which the property traded, and we know the cap rate, we can back-solve for the NOI with simple algebra. For instance, if we know the purchase price was $10,000,000 and the property traded at an 8 cap, we can multiply $10,000,000 by 8% to get an $800,000 NOI.
Likewise, if we know the NOI and the cap rate, we can back-solve for the purchase price. For instance, if we know the NOI is $800,000 and the property traded at an 8 cap, we divide $800,000 by .08 to solve for the purchase price of $10,000,000.
NOI is used as the measurement basis for cap rates because it is the most pure way to represent the operating income profile of the property. The NOI line sits above the debt service line in the property’s profit and loss statement, and inasmuch the yield calculated using NOI as the numerator it is not impacted by the existing capital structure of the property.
This is important because the existing capital structure may bear no resemblance to the capital structure of the new purchaser. The current owner might have held the property for more than30 years, and it’s unencumbered by any debt, whereas the new purchaser might use a 70% loan-to-value senior mortgage in its acquisition of the property.
To explain further why it’s an unlevered line item — NOI — that is used for cap rate calculation, imagine there is a situation where a purchaser has sufficient cash to purchase a property without using any debt financing, and there is no time to arrange for a loan given the seller’s desired accelerated timeline. If the buyer elects to acquire the property for all cash, then their NOI would be the same as their Cash Flow After Debt Service (CFADS) at the point of purchase.
In this case, the cap rate would be the same regardless of which of the two lines was used as the cap rate calculation numerator. But what if the purchaser then went the next day and put debt on the property? If cap rates were based on CFADS, is the purchaser’s cap rate that at which it was purchased (before any debt was placed on the property), or is it really based on the lower CFADS as of day 2 of the holding period?
In short, using NOI as the measuring stick prevents any tainting of the characterization of the operating income of the property related to financing. In this way, the cap rate paid for a particular property essentially reflects the attractiveness of that particular property’s expected ongoing operating cash flow stream. Therefore the cap rate is a phenomenal way to measure relative pricing (valuation) of two or more individual properties, or when looking at many trades in aggregate within a geographical radius, the relative pricing of one type of property vs. another.
Now the question becomes how one is defining NOI when stating a cap rate. It’s not always the same 12 months of NOI that are being used, so it’s important to know.
While the NOI used in the cap rate calculation is always on an annual basis, the NOI being used can be trailing NOI or forward NOI. Of the two types, trailing NOI is the more real figure because it captures historical actual values from property operation. But there are different ways to calculate trailing NOI, such as from the actual past 12 months as of the date of cap rate quote, or from the trailing 3 months of operation annualized, or the trailing 6 months of operation annualized. Of the three, the first is the most “real” — the other two are partially forecasts.
Forward NOI is somewhat more straightforward in that it’s either the forecast for the next 12 months as of the point of purchase, or (more aggressively) the NOI from the 12th month forward from the point of purchase, annualized.
NOI can also be reported before or after capital cost adjustments, so you need to inquire about this as well.
Capital costs are large inevitable property-wide capital expenditures (capex) required at every property as it ages — elevator replacement, roof repair, boiler replacement, etc. — as well as tenant improvements (TIs) and leasing commissions (LCs) for office, industrial and retail properties.
Because the timing and dollar amounts for these capital items varies wildly from property to property, sometimes cap rates will be quoted before any adjustments are made for capital costs i.e., ignoring these inevitable cash outlays for the purpose of valuation.
The alternative approach is to calculate the cap rate after adjustments have been made for “normal” reserves for TIs, LCs and capex. The operative question therefore to ask when hearing a quoted cap rate, is “Is that before or after reserves?” and if the latter, “what reserves are you assuming?”
There’s a lot to discuss on cap rates. Here’s more if you have an interest:
- the risk in assuming aggressive exit cap rate compression
- what’s the going-in cap rate on a real estate development?
- how discount rates are related to cap rates
- how cap rates are related to interest rates
- why you should forecast an expanding cap rate in your financial model
- cap rate spreads explained
- understanding the difference between cap rates and cash-on-cash return
- why forward NOI-based valuation makes sense to both buyer and seller
- what has a higher cap rate — residential or retail?
- truly understanding cap rates webinar replay.