Demystifying (or giving context to) the all-mighty "cap" rate in commercial real estate valuation.
A deeper dive into market extraction (comparables) versus the "band-of-investment" approach to cap rates.
“What’s the cap rate?” is the first question a buyer asks when pitched a commercial real estate investment. What they really want to know is: how is the seller valuing the property’s NOI? How much is the seller asking me to pay for the income or potential income stream generated by the property, keeping in mind that not all NOIs are created equal?
Simply put, the cap (or capitalization) rate is a percentage used to justify an asking price based on a NOI. The formula is NOI/Cap Rate=Asking Price. For example, if a seller is offering a property that it claims has an NOI of $135,000 and it is offered at a cap rate of 6.5%, the asking price would be $2,076,923 (or $135,000/.065=$2,076,923 likely rounded to $2.075 million). The other way to view this “asking price” is that the seller, asking $2.075 million for $135,000 in NOI has applied what it believes is a fair cap rate (for this property) of 6.5%. Change the cap rate, and you change the ask/value.
There are two main ways to derive a cap rate: Comparables (market extraction) or Risk/Return (band-of-investment).
The first (comparables) looks at what other similar properties in demographically similar locales with similar tenant mixes, vacancies, and deferred maintenance issues sold for, if the NOIs were also similar. (A meaningful comparable should also have sold at a time when interest rates reflected current credit conditions.)
The second (band of investment) looks at the cost of borrowing, possible loan-to-value ratios, the buyer’s tolerance for risk and desired return on buyer’s capital.
Investors, analysts, brokers and due diligence experts bat around comparables loosely, gathering 6-15 similar properties, trying to make sense of their differences. After all, the dominant factor in real estate is the uniqueness of each property.
But experienced brokers and investors know that there is no perfect comparable (except perhaps in true NNN, single-tenant, credit-rated tenancies) and that every property has a different risk profile.
So, if we find 10 comparable properties that have closed in a similar economic climate, that more or less share the same NOI, demographics, tenant-mixes, etc., we can extract a cap rate by looking at the average (or mean) cap rate for the 10 samples.
The lowest cap rate is 6.25%; the highest is 7.1%. But we cannot stop here. We need to look at the standard deviation of the data set. The standard deviation is a measure of the amount of variation or dispersion of a set of values. Using the STDEV function in Excel, we see a standard deviation of .2997%, meaning in general terms that most of the data set (most cap rates for the property) are +/-.2997 from the average cap rate of 6.71%, and you can comfortably propose a cap rate between 6.41% and 7.01%.
Had there been more variation in the cap rates, there would be a higher standard deviation, making the average cap rate a less representative sample of the data set, and rendering the comparables less useful.
In this instance, we look at 10 properties and see the average (or mean) cap rate is still 6.71%, but the difference lies in the standard deviation.
The standard deviation shows much greater diversity or range in the data sample of cap rates. The larger the standard deviation, the less useful the average or mean cap rate is in your data set of comparables. With a standard deviation of .7165, it would seem absurd to propose cap rates between 6% and 7.42% (adding or subtracting the standard deviation from the mean) — the variation makes the analysis almost meaningless.
In summary, the less variation there is in the data set, the more reliable the average or mean is. Of course, you may want to start valuation at the top of the data set, but that is a more a matter of negotiation than mathematics.
And, you cannot stop there. Regardless of what the comparable cap rate is, the investment still has to make sense given other factors, including the interest rate, loan-to-value ratio, available amortization periods and expected return on cash invested.
Let’s say that interest rates are 4.25% and amortization period is 30 years. From a mortgage constant table, we derive a constant of 5.903.
Let’s also say that LTV (loan to value) rations are 70%, that is a lender will finance 70% of the purchase price. On the buyer’s 30% cash invested, it requires a 9% return.
The capitalization rate under the band-of-investment theory is made up of the weighted average of the cost of borrowing and the desired return on cash invested.
So taking these factors and weighing them we see that at a 4.25% interest rate on a 30 year amortization, with an expected return on invested cash, the buyer can buy at a cap rate of 6.832% and still get its desired return. The weighted average adds 70% of the mortgage constant of 5.903 (.7 x 5.903%=4.132%) to 30% of the required return rate (.3 x 9% = 2.7%) for a total of 6.832% (4.132% + 2.700%).
Change any of the factors and the cap rate changes. At 75% LTV, the cap rate becomes 6.677%
Increase the Minimum Return, and the cap rate changes again. To get an 11% return, it would need to base its offer for the property on a cap rate of 7.177%, reducing the purchase price accordingly.
In sum, in order to compare the market price (NOI/Cap Rate) for a property to the investors desired return on its investment, both methodologies of determining a cap rate should be used. Both methods consider risk and return. In the comparables method, risk is factored in in the choice of comparables when selecting properties with similar characteristics. Testing the variations in the properties’ cap rates helps validate the rate. In the band-of-investment calculation, risk is factored in the desired return on the investor’s cash contribution. As most property is financed, the determinative factor in determining an offering cap rate is in the buyer’s perception of risk and requirement for an acceptable return on its cash invested.