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By Josh Panknin | July 2, 2020

“Cap rates,” short for “capitalization rates,” are one of the most discussed components of real estate valuation. Similar to the coupon rate on a bond, the cap rate is a measure of the return on a real estate investment that an investor can expect to achieve in the first year of ownership if they were to pay all cash for the property. This is often referred to as the 1-year forward net operating income (NOI). The valuation could be performed for a new acquisition, a refinance, or simply to give an owner a better idea of the current market value of the property. In this paper I will discuss the process of determining an appropriate cap rate, accurately forecasting net operating income, and what factors need to be considered when adjusting the cap rate based on economic trends and real estate market indicators. Before we get to that, though, let’s  go through the process of applying a cap rate to determine the value of a property with a simple example.

## How Do You Use a Cap Rate When Valuing a Property?

Let’s say an investor is looking to purchase an office building. After some due diligence and reviews of the financial performance of the property, the investor determines that the NOI of the property during the first year of ownership will be \$1,000,000. In order for the investor to determine the market value of the property, the investor needs to apply the cap rate to the NOI of \$1,000,000. The formula for this is:

Net Operating Income (NOI) / Cap Rate = Market Value of the Property

In this specific market, the investor learns that the cap rate for comparable properties is 5.0%. The value of the property is determined by dividing the NOI (\$1,000,000 in this case) by the market cap rate (5.0% in this case). \$1,000,000 divided by 5.0% is \$20,000,000. Thus, the investor determines that this particular property is worth around \$20,000,000 at this point in time.

Net Operating Income:                                                          \$1,000,000

Capitalization Rate (Cap Rate):              /                          5.0%

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Market Value of the Property:                 =                       \$20,000,000

To think of it another way, an investor in this market is willing to pay \$20,000,000 all cash today in order to receive \$1,000,000 in income during the first year, equaling a 5.0% return to the investor. One caveat of using a cap rate to value real estate is that, as mentioned above, the rate is typically applied to the expected NOI received during the first year (1-year forward NOI) of the hold period after the valuation is performed. Because the cap rate is applied to only one year of NOI, a valuation performed solely using the cap rate method is a snapshot of value at a specific period of time rather than an estimate of the overall return an investor is projected to achieve during the entire hold period. Therefore, a valuation using a cap rate differs from a valuation using a price per square foot method, discounted cash flow method, or replacement cost method.

### How is a Cap Rate Determined?

Real estate professionals will often discuss what recently sold properties “traded at.” This refers to metrics such as the sale price, price per square foot, or the cap rate applied to the property at the time of sale. Just as other asset classes have metrics that determine what level of returns investors are requiring (P/E ratios for equities, yield for fixed income, etc.), commercial real estate investors often use cap rates from the transactions of comparable properties to determine current market pricing. When evaluating the metrics of comparable properties, investors must first ensure that the comparable properties are of similar type and quality as the subject property. This means comparing properties in similar locations or submarkets within a larger market, Class A properties to other Class A properties, office buildings to office buildings, and a myriad of other factors such as quality of tenants, stability of cash flows, and capital expenditures and renovations. However, you will rarely, if ever, find comparable properties with the exact same characteristics as the property you’re currently trying to value. Often there are differences in the quality of the tenants, concentration of lease expirations, the physical condition of the properties, economic and real estate market conditions at the time of sale of the comparable properties, and many other factors. Because of these factors, investors usually make adjustments to the market cap rate to account for differences in property-specific factors and trends in market conditions.

### Property Specific Adjustments to Cap Rate

Though the mathematical calculation of dividing NOI by a cap rate to determine the value of a property is straightforward, there are many factors that an investor might consider when determining how to adjust either the cap rate or the NOI of the given property. In reality, there is usually a range of cap rates that will reasonably reflect the value of the property, depending on the perceived level of risk involved. It’s important to note that there is an inverse relationship between the cap rate and the value of a property. The higher the cap rate, the lower the value of the property, and vice versa. For example, a property with \$1,000,000 in NOI valued using a 5.0% cap rate will be \$20,000,000. However, the same \$1,000,000 in NOI valued using a 10.0% cap rate will be only \$10,000,000. For example, a property with a large number of tenants with leases expiring over the next year or two could lead to uncertainty around the stability of rent payments in the future. Thus, an investor may adjust the cap rate higher, meaning they are willing to pay a lower price for the property. While an in-depth discussion of the factors that need to be considered in determining an appropriate NOI are beyond the scope of this article, a thorough analysis of the stability of the future cash flow (i.e., rental payments) should result in a confident projection of NOI, as well as any risks of revenue loss.

## Real Estate Market and Economic Adjustments to the Cap Rate

The other major adjustment to a cap rate is typically made after considering the broader economic conditions. Trends in the overall economy and in the real estate market could have a major impact on the long-term performance of a property.

Previously, I discussed how changes to the NOI or the physical condition of an individual property could lead to adjustments of the cap rate by an investor. In addition to characteristics of the property itself, investors must also be aware of changes in the wider real estate market by performing a market analysis. A thorough market analysis will review trends in rental rates, vacancy, absorption, new developments in the area, etc. All of these factors should be considered to determine whether the performance of the real estate market will improve or decline in the future. In periods of positive economic growth, the value of real estate typically increases, providing a good opportunity for real estate investors to capitalize on the trend. However, in periods of negative or stagnant economic growth, the value of real estate typically declines. An investor should be aware of where in the cycle the valuation is occurring and adjust the cap rate accordingly to account for these future changes in the market.

Real estate is heavily impacted by changes in overall economic conditions. Increases in unemployment, rising interest rates, consumer confidence, and other influences can change the need for and value of real estate significantly. While there are many reasons the economic environment can change, forecasting in what direction it will change (positive, negative, stable) is an extremely difficult thing to do. In the past twenty to thirty years, real estate has become a much more mainstream asset class, joining equities and fixed income, among others. The rise of Real Estate Investment Trusts (REITs) opened real estate to the equity markets and Commercial Mortgage Backed Securities (CMBS) opened real estate to the fixed income markets. As a result, large investors now consider not just the potential return of investing in real estate, but also the potential return of investing in real estate relative to other asset classes. A more bullish perspective on equities, for example, could lead to capital being pulled from the real estate market for placement in equities.

### What is a “Good” Cap Rate?

This question is asked by many people new to the real estate industry. The simple answer is that there is no formulaic way to determine what a “good” cap rate is. The number of considerations that are included in determining a cap rate (or even a cap rate range), some of which are given above, are numerous and balanced in different ways depending on different economic, real estate, and property-specific factors. The best way to feel comfortable with a given cap rate is to perform in-depth analysis on these factors and come to a conclusion about how well you think a given property will perform in the future. The better you know the real estate business and the better you can analyze all the potential inputs to an analysis, the better able you will be to balance these factors for better decision-making.

### Closing Thoughts

The sections above provide an introduction to cap rates and to the major considerations of applying cap rates to commercial real estate. Property-specific factors, real estate market factors, and broader economic factors must all be considered holistically when finding and adjusting cap rates. Although we can often track data on economic and real estate markets, there are others such as pandemics, terrorist attacks, etc. that we can’t predict. The current COVID-19 crisis illustrates the ripple effects from economic shocks to shocks in the real estate market. It’s uncertain as to how the COVID-19 crisis will play out and the medium- to long-term impact on the real estate market, but we’re already experiencing significant impacts in the performance of the real estate industry, which will no doubt be reflected in changes to cap rates. Valuation of real estate using cap rates is an essential method to understand the current market value of a property. While there are multiple methods of valuation, each with their own merits, the cap rate method is not only a great place to start getting an idea of the value of a property, but also provides an important foundation for understanding the future performance of a property.