Transcription
The cap rate is one of the most widely referenced investment metrics in all of commercial real estate. But despite how popular the cap rate term is, this still tends to be one of the most misunderstood metrics in the entire real estate industry.
A quick Google search will tell you that the cap rate is just a property's net operating income or NOI divided by the property's purchase price. But even though this is an extremely basic calculation, there is so much more to this metric than just a simple division problem. And there are a lot of different factors that end up affecting cap rates in a market. And while a higher cap rate does mean a higher yield for investors going into a deal, that doesn't necessarily mean that that deal is more profitable than a lower cap rate transaction, or even profitable at all.
So, to address some of the most commonly asked questions inside Breaking the CRE coursework and from Breaking the CRE Academy members, in this video, let's take a step back and talk through what cap rates actually are, what drives cap rates up or down on commercial real estate deals, and some rules of thumb that you can use to know where a property that you're analyzing might fall on the cap rate spectrum.
So, like I mentioned in the beginning of this video, the cap rate is just calculated by taking a property's net operating income, or operating revenue minus operating expenses, and then dividing this by the purchase price of a property, or the proposed purchase price of a deal you're looking to invest in. And for a quick and easy property valuation, the cap rate can be a great way to estimate the approximate value of a real estate deal you're looking to buy without having to build out a complex multi-year pro forma model and without having to make a bunch of assumptions around the operations of the property many years into the future.
However, with that said, where most people get tripped up with this metric is around deciding what a cap rate should be on any given deal they're analyzing, why a cap rate would be low or high compared to other real estate investments in the market, and how to actually use the cap rate as a benchmark when valuing commercial real estate deals.
So, to help you get some more clarity around the application of this metric and how cap rates might play into your own investment analysis, in this video, let's break down the three main drivers of commercial real estate cap rates and how each of these has a direct effect on values in the commercial real estate market.
So, the number one driver on this list is probably the easiest to understand and the most applicable when it comes to a general rule of thumb around this metric, and that is that cap rates are driven by the expected income upside of the deal being analyzed. Since the cap rate represents the initial unlevered NOI yield, or the net operating income as a percentage of the purchase price, a lower cap rate represents a lower initial yield for investors, while a higher cap rate represents a higher initial yield. And as a general blanket statement, real estate investors are usually going to be willing to accept that lower initial yield on their investment if they believe the income of the property will be significantly higher in the future, sacrificing today's returns for potential upside down the road. And if investors don't see much growth potential in the income of the deal, this is when a higher initial yield is going to become a lot more attractive to make up for the lack of potential income growth over the long term.
This is why you'll usually see the lowest cap rates in coastal, supply-constrained markets with significant projected future rent growth. And you'll usually see the highest cap rate values in low-density Middle America markets where supply can outpace demand very, very quickly. This is also why you might see a value-add or opportunistic deal on the lower end of the cap rate spectrum, since the going-in NOI is very likely to increase quickly with releasing or renovation efforts raising rent to the property.
I've mentioned this in another video on this channel talking about why cap rates don't really matter, but my point in that video is that real estate investment firms aren't going to base their entire valuation on a cap rate metric exclusively, but instead are going to be looking at a target IRR, equity multiple, and or cash-on-cash return, with the resulting cap rate really just being a byproduct. So, while a 3% cap rate deal and a 6% cap rate deal that each trade for $10 million might not look comparable from a first-tier NOI perspective, if that 3% cap rate deal is about to undergo a major renovation and the NOI is expected to increase by 30% over the next three years, for example, while the 6% cap rate deal is already 100% occupied and the NOI is projected to increase by only 10% over the next three years, that 3% cap rate deal might actually produce a higher IRR over that three-year hold period, even with a significantly lower going-in yield.
Now, closely related to target IRR values and long-term cash flow projections on a deal, the next major factor that's going to impact cap rates is the current state of interest rates and the risk-free rate in the market. Interest rates don't affect NOI values, since debt service isn't factored into the equation, but interest rates do impact borrowing costs, which directly impact cash flow distributions to investors, affecting IRR and equity multiples that investors can ultimately earn.
And for an example of this, let's take a look at a deal with a going-in NOI of $500,000 per year, financed at a 70% LTV ratio with assumed cap rate expansion of 5 basis points per year, and investors looking for a 15% IRR over a 10-year hold period. And assuming the loan is full-term interest-only at a 3.25% interest rate, to generate that target 15% IRR, the property could be purchased for a little over $10 million, or a 5.0% cap rate. However, in this same deal scenario, if interest rates jump by just 100 basis points up to 4.25%, that $10 million investment in this same property would now produce only a 13% IRR over that same 10-year hold period. And to hit that initial 15% IRR target, investors would now need to drop their purchase price by over 10%, or $1 million, which, as a result, raises the cap rate on the deal by 60 basis points up to 5.6%.
And when this happens on a large scale, as interest rates rise and fall, cap rates also tend to rise and fall. And this is especially true when the major players in the market are large private equity firms that raise capital in their funds based on predetermined investor return expectations that generally aren't going to change every time interest rates fluctuate. Ultimately, for real estate investment firms, if borrowing costs increase, cash flow is very likely going to decrease, which directly leads to lower IRR, equity multiple, and cash-on-cash returns, inevitably resulting in a reduction in offer prices at the same NOI values, causing a rise in cap rates in the process.
And finally, aside from income upside and the state of interest rates, the last big factor on this list that's going to determine where a property falls on the cap rate spectrum is the risk of capital loss at the property level. Real estate is known by investors to produce what are referred to as bond-like cash flows. And when determining the value of a bond, investors are going to take a hard look at the bond's credit rating to determine their risk of loss on the investment. And as a general rule of thumb, as risk decreases and moves towards zero, investors are going to be willing to see a lower yield on their investment, while junk bonds, or bonds with poor credit ratings, tend to need to offer significantly higher initial yields due to an increased risk of loss.
The longer the bond is held, and for real estate investors, the cap rate is going to represent that initial yield. And following this same pattern, investors are usually going to be willing to accept a lower cap rate on an office building that's 100% occupied by Google or Apple, for example, but will usually demand a higher cap rate on something like a single-tenant retail property occupied by a brand new, unproven restaurant. This is also why multi-family properties tend to see some of the lowest cap rates of any product type in the industry, since this asset class has historically been one of the least volatile and offers a very diversified income stream with dozens or even hundreds of tenants on most multi-family deals. And this is also why product types like hotels tend to see some of the highest cap rates in the industry due to elasticity of demand and the fluctuation in income based on economic cycles or even the time of year in general.
The closer a real estate deal is to a risk-free, hands-off investment, the lower the cap rate is usually going to be due to the lack of perceived risk, the minimal operational requirement, or long-term leases with pre-determined rental values that provide some level of income certainty for the investor in the deal.
Overall, cap rates can vary a lot based on the property type, the business plan, macroeconomic factors, and the risk profile of a deal itself. But in general, you're going to see lower cap rates on deals with high income upside or a very low risk profile in a low interest rate environment, while higher cap rates tend to exist on properties with lower income upside or a higher risk profile when interest rates are high.
And if you're looking for more training on real estate valuation and analysis outside of just using a basic cap rate calculation, and want to learn how to build out a real estate financial model that calculates metrics like the IRR, equity multiple, and cash-on-cash return automatically, make sure to check out our all-in-one membership training platform, Break Into CRE Academy. A membership to the academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis. You'll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, our entire library of pre-built acquisition, development, and waterfall models for multi-family, industrial, office, and retail deals, and you'll also get access to private one-on-one email-based career coaching if you're looking to break into the industry and want some additional guidance and feedback along the way.
And if you like this video and want to see more content on this channel on commercial real estate return metrics, make sure to hit the like button to let me know. And let me know in the comments if there are any other calculations or metrics that you'd want to see covered in a deeper dive on this channel. As always, thanks so much for watching guys. I hope you found this helpful. Subscribe to the channel if you haven't already to see more videos like this every single week, and I'll see you in the next one.