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Commercial real estate cap rates (capitalization rates) and cash-on-cash return explained beautifully by Wharton Emeritus Professor Peter Linneman.
- Cap rates are a somewhat imprecise but highly common way CRE business people refer to property NOI yields and property values
- Cash-on-cash return measures the property’s return to cash given leverage on the property, and obscures the inherent income-generating character of the property itself
Bruce Kirsch: –to talk about capitalization rates, which everybody abbreviates as cap rates. And it can be a little bit tricky with cap rates because cap rates are at the same time the determinant of a property’s value but also simply mathematically the result of a property’s value given a certain assumed NOI stream. And so this somewhat circular nature, I think, can be confusing for students. How can a student reconcile these two things in their head– the property value and the cap rate?
Dr. Peter Linneman: Well, I think it’s very simple because it, as you describe, picks up two different things. If you start with the simplest one, if I bought something that has a million dollars in let’s say prospective NOI, and I’m buying it for $10 million, we’d say the cap rate– you and I would both say the cap rate on that purchase was 10. And yeah, we would basically be saying, is that a stabilized income stream? And were there adjustments to the purchase price because you got special financing? And yeah, we’d make all those adjustments.
But unless there’s a special story, if you bought something with a million cash stream for $10 million, you’d say it’s a 10 cap. And everybody in the business would understand. It’s more or less that math. And nobody would believe it’s exactly that math. There’s a lot of little shades of gray in both the numerator and the denominator, both the income and the value.
So one way it’s used is as you suggest just a descriptive. And everybody in the business knows that it isn’t quite as precise as you say, especially given we’re using prospective income. Because who knows what perspective income really will be?
So part of it is just truly using it as a descriptive. It’s nothing more than a shorthand to give people some sense of what the pricing is. Then you go to the flip side of that same coin. And the flip side of that coin is if you and I as professionals were talking, and I’d say, I’m not willing to buy it at a 10 cap, it has to be a 10 and a quarter cap, what you would know is that I think it’s a little bit overpriced but not crazily overpriced. There’s a 2 and 1/2% that I think it’s too much. 10.25 versus 10, the difference is 2 and 1/2%.
And so, OK, you’d know that what I meant is in that range, but you got to bring it down a little in price. And it’s again just language. It’s code language. And you would know that you don’t achieve that simply by redefining things but that I really believe the price is a couple percent too high. We got to make some adjustments somehow.
Or there’s not going to be a transaction. Or if I’m a seller, I’d say, I need a 9 and 1/2 cap. And you’d say, oh, we got to get a 5– to 5%. That’s a big gap. I don’t know if we get there.
So as used among professionals, it’s language. It’s lingo. And everybody’s making these conversions kind of like I’m saying. It’s not used with quite the precision that I think students think it might be being used with with this extreme mathematical precision in either case either as a descriptive of what I am going to do or a descriptive of what I have done so much as an indicator of where my head’s at.
And it’s almost like flying. The beauty of flying is it’s precise in precision. Cap rates have that. It’s very quick professional slang to both describe where my head’s at and where a transaction occurred.
Bruce Kirsch: Right. And one of the things that students ask me about cap rates is, well, why is this one of the most relied-upon metrics? If we’re going to end up putting debt on the transaction, doesn’t it make sense to look at the cash on cash return? And I tell them that the NOI and the cap rate, which is the yield on the purchase price, is really the purest measure of the income-producing characteristics of the real estate.
Dr. Peter Linneman: The purest, simple one. I mean, you could make it more complex by saying, well, in the first quarter, the cap rate should be in the fifth quarter in the 19th quarter. And that’s all there. But if you’re trying to– again, it’s a shorthand language. It is just a descriptive that if I tell you what the property is, I tell you the nature of the property, its lease, and its location, and what I think rents are going to grow, it is a pure descriptive.
Now, it’s not the only thing you look at. You look at a lot of things, starting with where it’s located and what the leases are and who are the tenants and do you like the design and real real estate stuff. But it is a simple descriptive.
And the cash on cash is a bit of a different statement. It’s not telling you about the property whereas a cap rate is telling you, as you describe, the cash-generating ability of the property at least in your belief relative to the price you paid or will pay. The cash on cash is telling you that. But it’s also mixing in with it how you chose to finance it. And it’s a very useful and important piece of information.
But it is not– and I think your word is right– pure about the property. It’s also telling you about the type of debt you got and how much leverage you chose to get. Well, that’s the choice of do you want to eat your pasta on a paper plate, a plastic plate, a silver plate, a fine china? The pasta is still the pasta.
So you can think of the cap rate talking about the pasta. The cash on cash is telling you about not just the pasta but how it’s served to you. And depending on your circumstances, you may want paper plate or fine china. And one is not right and the other wrong. It’s what are you dining at? What is your preference? What is your risk tolerance and so forth?
And so cash on cash, as you know, I could borrow for truly overnight in today’s market for essentially zero interest rate. So I could tell you my cash on cash is really huge. But it’s only for one night. Tomorrow, the debt’s due, and it’s a different answer. And I’m at risk that I can’t repay the debt tomorrow and all those kind of financing risk and leverage good and bad. The cap rate’s telling you about the property, not my decision of how to finance it.