Cap rate or capitalization rate is the most commonly used valuation metric used by real estate investors to evaluate if a cash flow producing real estate asset is “cheap” or “expensive.” Cap rates are the real estate equivalent of Price to Earnings or Price to Cash Flow multiples for equities.
Cap rate = Net Operating Income (NOI) / Value of Asset
The first step towards identifying the cap rate of a property is to calculate the Net Operating Income (NOI).
How do you calculate net operating income (NOI)?
Net operating income (NOI) is a commonly used cash flow metric amongst real estate investors. NOI is meant to be a true approximation of the cash flow production of an asset. In other words, NOI is what real estate investors receive in their pockets after all cash expenses but before debt service payments. NOI does not include deductions for non-cash expenses such as depreciation.
Let’s look at a hypothetical income statement for a multi-family building.
Income Statement for Garden Style Apartment Building
For the twelve months ending 2018
Rental income $1,000,000 Pet fee income 50,000 Total Revenue $1,050,000 Operating Expenses Labor $(100,000) Utilities (60,000) Maintenance (40,000) Management fees (42,000) Insurance (20,000) Total Operating Expenses $(262,000) EBITDA $788,000 Property taxes (88,000) Capital expenditure reserve (40,000) Net operating income $660,000
Note the following about calculating NOI:
- NOI takes all revenue received by the property and deducts all the cash operating expenditures such as the cost of labor, insurance, management fees, maintenance, insurance, etc.
- Revenue less all operating expenditures gives us the EBITDA for the property, which is Earnings before Interest, Taxes, Depreciation, and Amortization. For a refresher on EBITDA, please refer to Part 1, Lesson 12 of our A-Z Investing Guide
- From EBITDA, we deduct property taxes owed to the local government and the capital expenditure reserve
- Capital expenditure reserve: Since the capital expenditure needs of a building are often sporadic and lumpy, owners of real estate assets will set aside a fixed amount of dollars every month (or year) to cover future capital expenditure needs such as repairing a roof or replacing the HVAC system.
For apartment buildings, a typical metric used by real estate investors is a capex reserve of $400 per unit per year. If we assume Garden Style Apartment has 100 units, this would result in a $40,000 capex reserve for the year. Even if the $40,000 is not spent, we still deduct the capex reserve to calculate NOI since it is cash that is being put aside (and therefore, not available for distribution to the owner)
- You will notice what is missing from the calculation of NOI, a deduction for interest expense and depreciation. Interest expense is not deducted in the calculation of NOI since real estate owners can use vastly different leverage (loan) amounts, which would compromise the comparability of NOI between properties.
For example, if Building A has a loan that is 70% of building value while Building B has a loan that is 20% of building value, the interest expense associated with Building A will be much higher relative to Building B. However, the interest expense associated with a property does not tell us anything about its operating performance or efficiency. Instead, the interest expense is simply a reflection of the risk tolerance of the owner.
Additionally, depreciation is not included in the calculation of NOI since depreciation is a non-cash expense and does not affect how much cash the property generates
The Importance of Comparability of NOI
Within the various real estate sub-sectors, there are nuances as to how NOI is calculated. Much of the difference in how NOI is calculated is based on different practices for the accrual of a capex reserve. For example, for multi-family assets, most investors calculate NOI based on a capex reserve of around $400 per unit per year. In the hotel industry, the capex reserve is typically set at 4% of revenue. In the shopping center industry, the capex reserve is determined based on a square footage basis.
Since each asset class within real estate has a commonly accepted capex accrual methodology, investors will apply the industry standard for capex reserves when calculating the NOI of the property regardless of what is in the Seller’s financials. For example, let’s say an investor is looking to purchase a multi-family property, but the prior owner only accrued $100 per unit per year in capex reserve. Any potential buyer of this asset will adjust the Seller’s financials to reflect a more realistic $400 per unit per year.
Additionally, investors in real estate will adjust the property financial statements to reflect the market rate for third party management fees. For example, in the hotel industry, the standard management fee for a third party to manage the hotel is 3% of revenue. For multi-family assets, the third party management fee is higher at around 4%.
Adjusting for both the capex reserve and third party management fees, investors can compare properties on an apple to apples basis, which makes cap rate comparisons more meaningful. For example, investors will typically look at the cap rates for other comparable buildings that have sold to judge what type of cap rate they are willing to pay for their own investments.
Let’s assume that there are three Class A apartment buildings that have sold in Washington DC at a 5.50% cap rate, 5.55% cap rate, and 5.85% cap rate. If the 5.85% cap rate building was calculated using an NOI that included only $50 per unit per year of capex reserve, then, we know the NOI is overstated (due to the very low capex reserve) and therefore, the cap rate is too high. For cap rates to be truly comparable, the underlying NOI must be calculated using the same assumptions for capex reserve and management fees.
Cap Rate Calculation
Once we calculate the NOI using the sector appropriate capex reserve and management fee assumptions, the cap rate calculation is very simple:
Cap rate = NOI / Asset Value
Or in the case of a purchase of an asset:
Cap rate = NOI / Purchase Price
In our above example, Garden Style Apartment Building had an NOI of $660,000. Let’s assume that a buyer is under contract to purchase this property for $12,000,000. What is the cap rate?
Cap rate = $660,000 / $12,000,000
Cap rate = 5.5%
Cap rate represents the return an investor would receive if the investor were to pay for the asset with 100% equity. Therefore, if an investor paid $12mm of cash (no mortgage), this investor will earn a 5.5% return on their money.
However, in real estate, most investors try to leverage their returns by borrowing money at a cheaper rate than their cap rate. In this example, if the buyer of Garden Style Apartment Building can borrow at an interest rate of less than 5.5%, this would boost their overall equity return.
Historic Multi-Family Cap Rate
Below is a chart of the historic multi-family cap rate trend plotted against the 10-year treasury yield.
What affects cap rates?
Since cap rates are a type of valuation multiple, many of the factors that affect valuation multiples also affect cap rates. Most real estate trades between a 5-10% cap rate although there are certainly outliers to this range. Where a specific assets trades at within this range is determined by several factors, including:
Growth – the expected growth rate of NOI is a big driving force behind cap rates. If an investor believes the NOI of the property is not yet at a stabilized level or there is significant future upside in NOI (which might be achieved after a renovation of the property), then, the cap rate may be lower since an investor is willing to pay more with the expectation of better future growth
Asset type – the asset type dictates cap rates due to the perceived risk associated with a particular sub-sector. For example, nursing home assets are considered higher risk, so nursing home properties typically trade at higher cap rates to compensate for the higher risk. Nursing homes typically trade closer to a 10% cap rate. On the flip side, multi-family has a lower risk profile, so investors are willing to pay more for these assets resulting in lower cap rates. Depending on the market and quality of asset, multi-family trades anywhere in the 5-7% range
Location – risk is also determined by location. Desirable urban areas, like Manhattan or Beverly Hills, are viewed as having less risk than rural locations. Therefore, dense, urban markets typically carry lower cap rates. Additionally, many big cities are seen as having better long-term growth prospects than suburban or rural areas. For example, in 2018, hotels in large urban areas, such as Los Angeles or New York trade around a 5% cap rate. However, hotels in suburban markets trade closer to an 8% cap rate
Asset condition – assets that are in older condition or in need of repair will typically trade at a higher cap rate since the investor expects to spend more on maintenance and capex, which will lower the NOI performance. Therefore, a higher cap rate compensates for the additional dollars that will need to be spent upfront and/or the additional dollars that will likely be spent down the road to maintain the physical condition of the building
New supply – if a market has material new supply that will be competitive with an existing asset, then, this existing asset will likely trade at a higher cap rate to compensate investors for the additional risk of new properties which may take business from the existing ones
Interest rates – since many real estate investors employ the use of financial leverage when purchasing a property, the profitability of real estate is directly related to prevailing interest rates in the economy. For example, if a commercial real estate mortgage carries a mortgage rate of 6.5%, then, it will be tough to purchase an asset with a 6.0% cap rate (unless the property is expecting strong NOI growth) since the 6.5% cost of financing is higher than the 6.0% return. However, if the mortgage rate were to drop to 4.5%, then, this asset at 6.0% cap rate becomes much easier (more profitable) to finance.
In the years following the 2008 financial crisis, the low interest rate environment led to steady declines in cap rates as investors bid up the price of real estate since the very cheap financing made the returns of cash flow producing assets very attractive.