A property’s cap rate is one of the most fundamental measures of its potential value to investors, yet the measurement is still widely misunderstood. Here we offer a brief explainer of how cap rate is calculated, its limitations, and how you can apply it to your investment decisions.
Let’s say you’re looking at two high-value properties and want to purchase one of them. The properties are in the same neighborhood and come with similar price tags attached. There’s only one question that should guide your decision: which of these properties is more likely to produce a greater return on my investment in a shorter period of time? As you likely know already, the metric used to answer that question is capitalization rate.
As a seasoned real estate investor, you’ve probably calculated the capitalization rates of quite a few properties before. You know that it’s calculated by dividing a property’s annual net operating income (NOI) by its cost, and that it’s a good means of comparing the respective values of potential investments. You may have even already recognized cap rate’s advantages over other valuation metrics, including benchmarks like Gross Rent Multiplier (GRM).
But capitalization rate is far from a simple equation — to get an accurate sense of the rate at which your ROI will grow, you’ll need plenty of valid data, good projections, and a healthy understanding of how to factor investment risk into your calculations. Let’s break down some of the factors that determine cap rate, dispel some misconceptions that surround it, and run through some scenarios in which it may and may not be useful.
As discussed earlier, capitalization rate is defined by the formula “NOI divided by property cost or value.” But while determining property value is as easy as checking the listed price, calculating NOI can be difficult, and will require plenty of research into market and submarket activity, operating costs, and potential lease options among a whole host of other factors that might affect your investment.
Any decision you make in real estate should be dependent on an understanding of both the current and projected NOI of the properties in question. The property’s seller will usually be able to show you a current NOI, but the projected NOI will have to be based on a series of educated guesses: will you be able to fill all vacancies? Will your tenants be able to reliably pay the rent each month? How much will utilities cost, and can the tenants be incentivized to use them sparingly?
All this is to say that, while the seller may be able to readily supply an NOI figure, or you may be able to find one easily through some surface-level research, net operating income is actually a fairly subjective and difficult thing to measure. For example, sellers may artificially inflate the NOI they give you by collecting large, lump sum payments from tenants, or by deferring routine maintenance work in favor of physical renovations. Unless your source is exceptionally trustworthy, obtaining an accurate NOI, and therefore, an accurate cap rate, involves plenty of diligent research and difficult guesswork.
Why Cap Rates Fluctuate
Further complicating the issue of cap rates is the fact that they are subject to market trends at the local, state, and even national level. Property values are affected by local developments, like the addition of new jobs in the area that require the construction of new living spaces, while your NOI can be affected by far-flung world events, like a global conflict that results in increased oil prices. Fiscal regulatory bodies like the Federal Reserve can also indirectly alter cap rates on a local level.
For example, capitalization rates across the net-lease retail sector spiked at the end of 2016 for the first time since the third quarter of 2013, resulting in part from the Fed’s decision to raise interest rates last month. Higher interest rates mean higher costs of maintaining a mortgage for a property, which in turn drives property values down. Since cap rates have an inverse relationship to property value, investors are likely to see better returns on their investments in the next few years, as interest hikes are expected to continue well into 2018.
Given that real estate market conditions for the best they’ve been in some time, investors are likely looking to make purchases now while the odds are in their favor. But as we’ve discussed above, making an educated investment decision in this industry is a long and involved process. With so many variables at play, it’s hard not to second-guess yourself when moving towards a purchase.
Reonomy is working to clear away much of that uncertainty with our commercial property data platform. Instead of working through hours of long equations and phone calls with sellers, investors can simply look up a property’s value, NOI, and cap rate on Reonomy. Look into market trends by filtering your search to similar properties and extrapolating from the sales data you find. Find out everything there is to know about potential costs and issues that might arise, from zoning and tax laws to nearby transportation.
This easy-to-access, high quality data is precisely what drew Manhattan real estate firm Stonehenge to Reonomy. Their data provider at the time was “deficient, even limiting the amount of properties I could search,” says Stav Stern, an Investment Agent at Stonehenge. A demo proved to Stonehenge that Reonomy would offer them everything they needed from a data provider. “It used to be that if an off-market deal happened and we wanted to know the cap rate, it would have taken seven steps to get that information,” he says. “With Reonomy, it only takes one step.”
Cap rates can be tricky to pin down in today’s market, but they don’t have to be. Simplify the process of reviewing, vetting, and purchasing properties with Reonomy.