Level 1 Beginner:
Cap Rate as a valuation technique
The capitalization rate (cap rate) is a ratio between the sales price of a property and the net operating income (NOI) of that property. When you are purchasing an income-producing asset you aren’t purchasing a building. What you are purchasing is a stream of income. A cap rate is essentially the real estate equivalent of Wall Street’s price-earnings (P/E) ratio. Income multiples are also used to value private companies. On Shark Tank you constantly hear Mr. Wonderful ask what the company’s sales are: followed by “that’s ridiculous you want me to pay 12.5x earnings for this?” However, in the real estate industry we don’t use a 12.5x earnings multiple we use a yield stated a percentage—it’s the same thing just stated differently. To convert a earnings multiple into a cap rate or vice versa simply take the reciprocal—a 12.5x earning multiple equal to an 8% cap rate (1 divided by 12.5 is equal to 8%). The more you are willing to pay for a given stream of income the higher the earnings multiple—or inversely the lower the cap rate.
Here is the formula for calculating the cap rate:
Cap Rate = NOI / Purchase Price.
The cap rate and the purchase price are inversely correlated. Referencing the example below you will see a constant NOI; however, as the cap rate increases the purchase price decreases.
Level 2 Intermediate:
Why Use NOI Instead of Net Profit ?
The reason for using NOI instead of net profit is simple: net profit is a function of the debt and tax structure that is in place while NOI is not. NOI is constant irrespective of the debt and taxes that are placed on the property; this allows investors to use an apples to apples comparison between properties. Similarly when businesses are bought and sold, the income multiple used is often based on EBITDA (earnings before interest, taxes, depreciation, and amortization), because it shows how profitable a company is regardless of debt and taxes. NOI is like EBITDA but for real estate instead of companies.
Real Estate as a perpetuity
Real estate income streams can also be viewed as a growing perpetuity—with some notable differences, specifically, the future cash flows fluctuate, and aren’t perpetual. NOI growth is central to the evaluation of future cashflow. The higher the expected NOI the more that the buyer is willing to pay for the property, because increasing the NOI growth rate will increase the expected return. Using the constant growth model from finance. We can approximate how changing the NOI growth rate if a discounted cash flow (DCF) model would affect the purchase price the buyer is willing to pay for a given return requirement.
Here is the formula to value a growing perpetuity:
Perpetuity Value = Annual Dividend / (Expected Rate of Return – Future Growth Rate of NOI)
Decomposition of Cap Rates
Taking the constant growth model and applying it to real estate. Cap rates can be decomposed into two parts: expected return, and NOI growth rate. To increase the expected return of a property without increasing the cashflows, you must lower the purchase price (initial investment), this is reflected by increasing the cap rate. Conversely, if the income stream is growing, you are willing to pay more upfront because the future cash flows are increasing. This higher purchase price is reflected in the lower cap rate.
We can see in the example below that by increasing the NOI growth rate an investor would be willing to pay far more for the same investment property. However, the actual return doesn’t change in this situation because the increase in purchase price is counteracted by the increasing in NOI growth.
Level 3 Expert: Cap Rates a quantification of risk
Cap Rates as a Reflection of Demand
The most sophisticated investors view cap rates as a quantification of risk, or more accurately, the supply and demand for a given asset. When demand is low, prices fall; therefore the cap rate increases. However, demand is composed of two parts: the desire to purchase, and the ability to pay. You may want to purchase that red Ferrari, but if you can’t afford it then it isn’t truly demand. Similarly, given real estate’s high overall leverage, when the banks stop lending, demand decreases, and cap rates increase. Cap rates are a function of the flow of debt funds—as lenders relax their lending standards, buyer’s purchasing power increases, therefore increasing the demand. Driving the prices up, and cap rates down.
Cap Rates as a Reflection of Risk
There is a significant delta between the cap rates from Class A apartments and Class C apartments. This discrepancy can best be understood as quantification of the risk involved with purchasing a lower quality building, thus demanding a higher return. The reason that Class C buildings are considered more risky is the following: in the event of an economic downturn, a Class A apartment building would simply lower their rents and maintain the same occupancy rate. At a lower rent, more people can afford to live in the nicest buildings, as more people move into those higher quality buildings the lower quality buildings (Class C), have a higher rate of vacancy and are thus considered more risky.