Cap rate, or capitalization rate, is such an important topic in commercial real estate that we are going to cover it in depth. Commercial lenders use cap rates as a quick way to determine if an investment property makes sense. Applying a cap rate to the net operating income (NOI) provides a lender with a quick valuation of a cash-flowing property and is one of the first back-of-the-napkin hurdles a deal must pass before moving through the underwriting process.
Cap rate formula
While lenders use cap rate to estimate property values, real estate investors use cap rates to estimate the return on investment for a given cash-flowing property. It is calculated by dividing the NOI by the market value, or selling price, of a property.
Cap Rate = NOI/Market Value (or Selling Price)
NOI is a measure of a property's gross income minus operating expenses. Operating expenses exclude principal and interest loan payments, depreciation, capital expenditures, and income taxes.
Let’s assume a property generates $14,000 in annual NOI and the market value of the property is $200,000.
Cap Rate = $14,000/$200,000
Cap Rate = 0.07
Cap rates are expressed as a percentage, so in this example, the cap rate would be seven percent (7.0%).
Using the cap rate formula to compare investments
Let’s say you are looking at two different properties, both generating $20,000 in annual NOI. The first and second properties are selling with 5% and 10% cap rates respectively, so what is the selling price for each?
Using the cap rate formula above and some algebra, this is how we determine the selling price for the first property:
5.0% = $20,000/Selling Price
Selling Price = $20,000/5%
Selling Price = $400,000
The selling price for the second property is as follows:
10.0% = $20,000/Selling Price
Selling Price = $20,000/10%
Selling Price = $200,000
Why would two investments with the same NOI differ so drastically in price? While there are several factors for the variation in cap rates, usually the difference can be attributed to the property type, the property condition, or the property location. In the above example, the second property would be deemed a riskier investment, and thus, a buyer would demand a higher cap rate in return for the risk, which the seller is pricing into the deal.
Now, what if we want to calculate the NOI and only know the cap rate (5.0%) and selling price ($500,000). Back to using algebra, the formula would look as follows:
5.0% = NOI/$500,000
NOI = $500,000 x 5.0%
NOI = $25,000
What is a good cap rate?
We have already established that properties with higher cap rates represent a potential higher return for a real estate investor. So, the answer is it depends on the investor.
A passive real estate investor may want to purchase a property leased to a credit tenant such as McDonald's. These investments are typically based on a triple net lease or “NNN”, which means the tenant, in this case, McDonald's pays for the real estate taxes, property insurance, and common area maintenance. This type of investment is considered low risk and low maintenance for an investor, so this type of property may trade in the low 5.0% cap rate range depending on the credit of the tenant and terms of the lease.
Cap rate for less stable investments
Compare this to a small multifamily building where the owner is collecting rents, maintaining the property, paying the real estate taxes along with the property insurance. The cap rate for this type of property will be much higher than the example above because of the tenant quality and the hands-on nature of the property. Because of the perceived risk compared to the McDonald's property and the amount of work required a real estate investor will demand a higher return on their capital, you may see these types of property trade closer to a 10.0% cap rate.
From the examples, you can see that the investment strategy for an individual real estate investor will be a key factor in determining if a cap rate is good. In the examples above, the real estate investor that purchases the property leased to McDonald's is looking to clip coupons (collect recurring income) without much risk, while the other investor is looking to make a higher return on their capital and is not afraid of being highly-involved. Generally, the less time and effort an investor has to put into a property, the lower the cap rate or return on their investment.
How are cap rates determined?
Typically, cap rates are determined by looking at comparable properties to determine what the cap rate was, using the formula above, at the time of sale. Then, a seller or real estate investor can apply that number to the subject property.
But what if there are no direct comparables in the market? How would you or an appraiser determine the appropriate cap rate for a property?
Well, there is a formula that appraisers use to determine an appropriate cap rate for a given property. The formula is as follows:
Ro = (M ×Rm )+((1-M)×Re)
Ro: Overall Rate
M: Loan to Value
Rm: Mortgage Constant
Re: Equity Return
While the formula and calculation are very intimidating to the average real estate investor, conceptually it is determined by looking at the debt and equity components of a particular transaction.
As an example, say a lender is willing to lend at a 40% LTV on a given property versus another property where they may lend at a 70% LTV. Based on this information alone, we know there is going to be a significant impact on the cap rate with a change in just this single variable. In this extreme example (assuming all other factors equal), a single change to the LTV there can result in more than a 100-bps (0.01%) swing in the cap rate.
Using the cap rate formula to predict property values
Let’s have a little more fun with the cap rate formula by using it to help predict what might happen to a property’s value under different market conditions. So here are a series of “what if’s” based on hypothetical changes in market conditions (holding other variables constant):
- What happens if mortgage interest rates are going down? Lowering the interest rate reduces the mortgage constant (Rm). Holding all else equal, the cap rate should go down. Now, this part is a little counter-intuitive. If the cap rate goes down but the NOI remains constant, what has happened to the property’s value? That’s right . . . it increased.
Here’s an example. If I bought my property for $2,000,000 with a $160,000 per year NOI, my cap rate at purchase was 8%. Let’s say interest rates have gone down enough to reduce my mortgage constant so that my NOI now calculates at 7%. My property now is worth $2,285,000 ($160,000 divided by 7%). Maybe this will help. Under these new conditions, if I went to sell the property, the new buyer should want a 7% cap rate and thus would be willing to pay $2,285,000 for my property that generates $160,000 in NOI. Because of this, falling interest rates should increase the value of a commercial property (holding everything else constant).
- How about a recession, more specifically a “traditional” recession with falling demand for goods and increasing unemployment? In such an environment, lenders are likely going to cut their LTVs on new loans to protect themselves against the risk of default. That means that if you went to sell your property, the buyer likely would have to put up more money and borrow less.
Based on the formula, cap rates go up if LTVs decrease. Using our example from above, if my property continues to generate $160,000 in NOI but my cap rate has increased from 8% to 9% because of lower LTVs, then my property value now is $1,780,000 ($160,000 divided by 9%).
- Finally, what if there is reason to believe that returns on equity, or risk capital, are expected to increase? Maybe the government is cutting taxes. Again, holding everything else constant, if the Equity Return goes up, the cap rate goes up and the property value would go down. Think of it this way, if you can earn higher returns elsewhere on your risk capital, then you’ll want a lower entry point on buying a commercial property so that you have the opportunity to earn an equivalent return.
Where are Small Balance Commercial cap rates going?
While the likelihood of an average real estate investor needing to calculate a cap rate based on LTV, mortgage constant, and return on equity is zero to none, showing the formula helps us think about where cap rates might head.
In the current low interest rate environment, we can look at the formula and surmise that the single variable most likely to change is the LTV. Commercial real estate lenders do not like uncertainty (i.e. pandemics) and in the face of it, the easiest way to mitigate risk is to reduce the LTV on any given loan.
The next variable that will most likely be impacted is interest rates. Because interest rates currently remain largely unchanged, the base interest rates that most small balance commercial lenders advertise will most likely remain stable. However, small balance commercial lenders will certainly modify interest rates through “adjustments” to the base rate for factors such as rate structure, prepayment penalty, loan purpose, property type, location, etc.
As we know from the cap rate formula, cap rates are expected to increase due to the expected change in these two variables, but by how much remains to be seen. As of this writing, our economy is on the mend which should reduce rates across all property types. As they say on television, stay tuned. Check in regularly to read more about SBC lending, and check out the "Small Balance Commercial" section of our blog.