Cap rates (capitalization rates) are still one of the most-mentioned and least-understood elements of commercial real estate.
What is a cap rate?
The simplest way to define a cap rate is to say that it’s the percentage that results from dividing an operating property’s income by its purchase price. While this is true, that definition’s vagueness might do more harm than good in many cases, as nuance is critical in understanding cap rates as they relate to income-producing commercial real estate properties, namely:
How is the person reporting the cap rate defining “income”?
When we refer to property income (the numerator of the cap rate ratio), we might be referring to several different things:
- Trailing Twelve Months (“TTM” or “T12M”) Net Operating Income (NOI)
- Trailing Twelve Months Adjusted Net Operating Income
- Forward (projected as of the time of purchase) Twelve Months Net Operating Income
- Forward (projected as of the time of purchase) Twelve Adjusted Months Net Operating Income
This range of possibilities is one of the fundamental reasons for the confusion surrounding cap rates. Exacerbating matters is that the definition of “Adjusted” also needs to be detailed. When we talk about Adjusted NOI, we are referring to the property annual NOI less amounts for “normalized levels” of capital items:
- tenant improvements (TIs)
- leasing commissions (LCs)
- capital expenditures (Capex)
This raises another question, though — regardless of the NOI being used — which is: how are the parties in question defining “normalized levels”? Normalized suggests that the property is “stabilized” at the point of purchase. By stabilized, we mean the property is at, or near, full economic occupancy (maximum income generation less some systemic, to-be-expected vacancy for that property type in that sub-market), and that NOI is flat or growing relatively smoothly year over year.
So when we talk about Adjusted NOI, we are talking about NOI less some rationally expected average level of each of TIs, LCs and Capex needed each year. This introduces more potential discrepancies, though, because what is each party considering the definition of “rationally expected” is for each property? As a result, while in theory cap rates offer a fundamentally sound way to compare two properties to one another in terms of income generation relative to the property’s purchase price, we really don’t have a perfect measuring stick because there are subjective definitions applied by those involved in and reporting on the transaction (seller, buyer, broker). And it is for this reason that we can have disparate reports for the cap rate of the trading of a property (while the Purchase Price is always constant across reporting parties, the income amount is not).
Nonetheless, it’s the best metric we have that attempts to describe valuation on an apples-to-apples basis, so we take what we can get. Thoughts?
You described how to calculate an implied cap rate or initial yield on a property given a valuation, not what a cap rate is. Your definition would be like defining a bond’s yield to maturity as the coupon divided by purchase price without regard to whether the bond was purchased at a premium or discount. It’s much more important to understand how to determine a property valuation than to be able to back into the initial yield, particularly if your T-12 or in-place cash flow isn’t representative of the stabilized cash flow.
A cap rate is the growth adjusted discount rate applied to value the stream of cash flows beginning with your terminal cash flow. It is exactly the same as a multiple in stock terminology (1/(rate – perpetual growth) = multiple).
Similarly to how growth in one industry would impact the multiple of stocks within that industry, the same is true for property types in certain markets vs others – ie NYC apartment rent growth vs. Hartford CT apartment rent growth will account for a substantial portion of the difference between cap rates on apartment buildings in those markets.
If you think about real estate as an annuity, the cap rate would be the discount rate applied to a growing perpetuity.
This article is a better description of how to normalize property cash flow in order to apply a market cap rate than it is a definition of what a cap rate is.
Hi Mike, great clarification, thank you very much!
Could you view cap rates as what the market is willing to pay to own a specific stream of cash flow? It seems to me that what you described above is the property’s yield? If not, what’s the difference between yield and cap rate?
Hi Amit, yes, I like to think of the purchase cap rate (aka “going-in” cap rate) as a reflection of the attractiveness of that particular cash flow stream to the winning bidder. Regarding your second question, the annual cap rate is often referred to as annual “Yield on Cost”. There is no difference between the two concepts.