One of the most ubiquitous terms in real estate investment is the capitalization rate, most commonly referred to as the “cap rate.” Although foundational, cap rates can be misleading or even meaningless without a proper understanding of how they’re derived and their limitations in analyzing real estate investments.

What Is a Cap Rate?

A capitalization rate is derived from a very simple ratio of a property’s net operating income (effective gross income less operating expenses) to the property value (actual or expected property price). In other words, they communicate the unlevered return on the asset — the income from the property irrespective of particular financing.

NOI ÷ Purchase Price = Cap Rate

The cap rate is expressed as a percentage and is largely used as a barometer to understand what is happening to real estate values in the market. As demand increases for a geographic market or sector of real estate (i.e. Austin, TX, or multifamily assets), investors tend to accept a lower relative rate of return, thus a lower cap rate. And as cap rates and prices are inversely related, the lower the cap rate, the higher the price. Additionally, cap rates give investors a very basic idea of the perceived risk of an asset. As finance 101 teaches: high risk usually accompanies higher potential reward and lower risk usually indicates lower reward. You can apply this idea to cap rates: the higher the cap rate, the higher the perceived level of risk involved with that real estate investment, and correspondingly, the higher the expected return on that investment.

Why and How to Use a Cap Rate?

Property Comparisons

Cap rates take into consideration property performance as measured by the Net Operating Income (NOI) and asset value. These measures make it the preferred tool for comparing the value of similar deals to one another. Deals of the same property type with a similar style, vintage, location, etc. should have similar cap rates. If they do not, then you can dig further to understand whether the cap rate disparity is property performance (NOI) related, purchase price related (either a price that is below or above market), or a combination of both and whether or not the disparity is justified. Another way to quickly get an estimate of whether a potential investment is worth spending further time to analyze is by comparing the expected cap rate at the time of sale to the market cap rate for comparable deals in a similar location.

Internal Property Value Estimations

If you know the cap rate that comparable deals are trading at in a submarket and you know a property’s NOI, then simply dividing the cap rate by the NOI will give you an estimation of the property’s value. In fact, this is one method used at Timberland Partners to estimate the property values of our assets at any given time during their hold periods.

Cap Rate Nuances

In order to derive meaning from a cap rate you first need to compare properties that are of the same property type, style, vintage, and location. The second piece of context that is necessary to understanding a cap rate is the exact measure of the property’s income that is being used to arrive at the cap rate. Four of the most common measures of income that we see in the cap rate equation are the T12 – the actual net operating income over the last “trailing” 12 months; the T3 – the annualized most recent 3 months of revenue less the actual operating expenses over the last 12 months; the T1 — the annualized most recent single month of operating revenue less the actual operating expenses over the last 12 months; or the Proforma Yr. 1 – the expected net operating income of the first 12 months of ownership.

As you can imagine, these measures of NOI have the potential to strongly impact the cap rate for a specific deal. For example, if a multifamily property that is set to sell at a specific price just reached its first full month at an average occupancy of 95 percent, a T1 measure would indicate a higher cap rate (higher NOI at the same price) than a T12 measure. However, if the property had just completed its original lease-up, then perhaps the T1 would be a more accurate picture of the longer-term income potential to the property, and you could compare and verify this number to the submarket cap rate. If, however, it was a stabilized asset and was operating at 90 percent occupancy for many months, and coincidentally hit 95 percent the month prior to the sale, the analyst may not trust that a single month of better performance would indicate a trend for the asset. So, whether a T1, T3, T12, or even proforma income is used, the different incomes shown will produce different cap rates for the property. It’s up to the analyst to choose the most appropriate measurement for the asset.

Cap Rate Limitations

When analyzing a real estate investment, it is crucial to be aware of the limitations of a cap rate, namely that it does not account for future NOI growth or future price appreciation of an asset. The cap rate is a snapshot of property performance relative to property value at a specific point in time. Additionally, cap rates do not account for the cost of debt to own a property, which is a major factor in the cash flow and, thus, the investment performance of a real estate deal. Finally, a cap rate uses the NOI of a property, which leaves out any capital investment that is spent on the property for either repair or renovation to maintain that NOI or improve it. This capital expense may be a significant amount of money that could create a negative cash flow situation for the property, but as capital expenses are “below the line,” this is not accounted for in the NOI. So, by only using a cap rate to analyze a property, an investor may arrive at an unrealistic value for the asset and misunderstand the potential investment. These are just a few of the reasons to remember that although cap rates are an incredibly important tool for quick analysis of real estate values and risk, they are by no means a replacement for a full underwriting of a real estate investment opportunity.