Cap rates explained via mental models
The cap rate is a commonly used investment metric in commercial real estate. However, it's often misunderstood, even though it's just the ratio of a property's net operating income to its purchase price.
It may seem simple, but many factors can impact cap rates in the market, making it more complex.
A higher cap rate can mean a better yield for investors, but that doesn't always mean the deal is more profitable than one with a lower cap rate. To answer common questions about cap rates in commercial real estate, let's take a step back and discuss what they are, what affects them, and some rules of thumb for analyzing properties.
At a very high level, The cap rate provides a simple means of estimating the value of a real estate deal you want to purchase without requiring a complex multi-year pro forma model or assumptions about future property operations.
Many people have trouble understanding the meaning of a cap rate as a benchmark for valuing commercial real estate. For example, when a broker says this building is going for 8 cap, what does it really mean?!
To help you gain clarity on how the cap rate metric is used in investment analysis and its effect on commercial real estate values, let's break down the three main drivers of cap rates. Each of these has a direct influence on the CRE market.
The first driver is probably the easiest to understand. And the most applicable when it comes to a general rule of thumb around this metric, and that is that cap rates are driven by the expected income upside of the deal being analyzed.
When it comes to cap rates, a higher rate signifies a greater initial yield, while a lower cap rate indicates a lower initial yield for investors. Typically, savvy real estate investors will be willing to forgo a higher initial yield in favor of a potential upside down the road, assuming they expect property income to increase significantly in the future.
And if investors don't see much growth potential in the income of the deal, this is when a higher initial yield is going to become a lot more attractive to make up for the lack of potential income growth over the long term.
This is why in coastal markets with limited supply and a strong potential for rent growth, cap rates are typically lower. In contrast, in low-density markets in Middle America where supply can quickly exceed demand, cap rates tend to be higher.
This is also why you might see a value add or opportunistic deal on the lower end of the cap rate spectrum since the going-in yield is very likely to increase quickly with re-leasing or renovation efforts raising rents for the property.
I've mentioned in another newsletter why cap rates don't really matter in assessing the return profile of a deal. But in that newsletter, I was trying to convey that real estate investment firms don't rely solely on cap rates as a metric to determine their valuation. Instead, they consider other factors such as target IRR, equity multiple, and cash on cash return, with the cap rate being a byproduct of this analysis.
A 3% cap rate deal and a 6% cap rate deal trading for $10 million each might not look the same from a first year NOI point of view. But if the 3% cap rate deal is going through a big renovation and the NOI is expected to rise by 30% over the next three years, it could have a higher IRR compared to the 6% cap rate deal, even though the 6% cap rate deal is already filled and the NOI is expected to go up by only 10% over the same three year period.
Closely related to target IRR values and long-term cash flow projections on the deal, the second major factor that will impact cap rates is the current interest rates and the risk-free rate in the market.
Interest rates don't affect NOI since debt service isn't factored into the equation, but interest rates do impact borrowing costs, which directly impacts cash flow distributions to investors affecting IRR and equity multiples that investors can ultimately earn.
Let's look at an example. Say there's a deal with an income of $500,000 per year, financed at 70% of the value, with a cap rate that increases by 5 basis points each year. If the loan is interest only at 3.25%, that $10 million investment will get a 15% return in 10 years. But if interest rates go up to 4.25%, investors will only get a 13% return and need to lower their purchase price by $1 million, which raises the cap rate to 5.6%. When interest rates rise or fall, cap rates follow. This is especially true when large private equity firms raise capital, as they have predetermined investor return expectations that don't change when interest rates change.
If the cost of borrowing increases, real estate investment companies will likely have less money coming in. As a result, their Internal Rate of Return (IRR), Equity Multiples, and Cash on Cash Returns will decrease. This means that the offer prices for properties may also decrease, even if the Net Operating Income (NOI) remains the same. This can cause Cap Rates to increase.
The last major factor that will decide a property's cap rate is the risk of capital loss at the property level.
Real estate is known to investors for providing cash flows similar to bonds. When deciding the value of a bond, investors carefully consider its credit rating to identify the risk of loss.
And as a general rule of thumb, as the risk decreases and moves towards zero, investors will be willing to see a lower yield on their investment while junk bonds or risky bonds with poor credit ratings offer significantly higher initial yields due to an increased risk of loss when the bond is held for long periods.
And for RE investors, the cap rate is going to represent that initial yield, and following this same pattern, investors are usually going to be willing to accept a lower cap rate on a building that's 100% occupied by a credible tenant but will usually demand a higher cap rate on something like a single tenant retail property occupied by a brand new unproven tenant.
This is why multifamily properties usually have some of the lowest cap rates in the industry. They are not very volatile and offer a wide range of income from many tenants, sometimes even hundreds.
While asset types like hotels tend to see some of the highest cap rates due to demand elasticity and the fluctuation in income based on economic cycles or seasonality.
In general, the more secure a real estate deal is, the lower the cap rate is likely to be. This is because there is less risk involved, less operational work needed and the leases have long-term, fixed rental values. This gives the investor much certainty about their income.
To summarize the full sentiment of the post, the cap rates can vary a lot based on the property type, the business plan, the macroeconomic factors, and the risk profile of a deal itself. But in general, you'll see lower cap rates on deals with high-income upside or a very low-risk profile in a low-interest rate environment. In comparison, higher cap rates tend to exist on properties with lower income upside or higher risk profiles when interest rates are high.
That's a wrap.