What are Cap Rates?
June 30, 2017 | by Beth Glavosek | Blue Vault
If you spend any time around commercial real estate professionals, chances are good that you’ll hear the term ‘cap rate.’ Short for capitalization rate, the term offers a metric for a real estate asset’s performance. Cap rates’ ups and downs are a frequent topic of discussion in real estate forums.
But what should investors and advisors understand about them?
Why they are important
A cap rate is a reflection of the expected returns that real estate properties can produce. Investors and advisors can look at them as just one way of gauging expectations for how the investment might perform.
Cap rates are taken into account when properties are acquired and when they undergo valuations. For example, if a real estate company is considering acquiring a property from another owner, it will want to know what the cap rate is because it’s reflective of the amount of income the building is generating.
The value of a property at acquisition is sometimes described in terms of its cap rate to provide a reference or relative value to other similar transactions occurring in a similar timeframe.
How they are calculated
Real estate investments produce income available to investors in the form of Net Operating Income (NOI). This is the revenue a property generates adjusted for normal operating expenses. One method of estimating the market value of a REIT’s portfolio of properties is to “capitalize” the REIT’s NOI using a cap rate.
The math is simple: Estimated Property Value = NOI/Cap Rate
As with stock or bond investments, this equation relates the value of the investment to the average return it is expected to produce. It is an inverse relationship. The lower the cap rate for a given level of NOI, the more valuable the property.
A common misconception is that cap rates somehow equate to distribution yields. This is not the case. Just as Earnings/Price (E/P) ratios are not the same as dividend yields for common stocks, cap rates are not the same as distribution yields for REIT shares. Neither metric captures the rate of return to be expected or realized at the end of the investment holding period, because both are based upon current conditions and current valuations only, rather than long-term changes in cash distributions and share values. Remember that cap rates relate current levels of NOI to current valuations while NOI can be expected to grow over time. Other things equal, the higher the expected rate of growth in NOI, the lower the cap rate for a given property or portfolio.
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