back to Cap Rate data

Cap Rate definition

 

 

 

What is a cap rate?

 

 

 

Cap Rate Definition

A real-world definition of the commercial real estate Cap Rate

plus, DCF, Yield, and IRR explained.

 

 

 

      Cap Rate

 

 

  Year 1  NOI          = Cap Rate

     PRICE

 

A Cap Rate is simply the rate of Year 1 Expected Net Operating Income / Price. Future expectations - beyond Year 1 are not mathematically involved in the intentionally-simple Cap Rate math.

 

 

 

The Cap Rate formula excludes these relevant items:


1)
 Changes in cash flows after Year 1

 

       1) Known changes - like lease expirations & rent increases
       2) Unknown changes - like market vacancy and inflation
 

2) "Below NOI expenses"


       1) Tenant improvement costs (those not paid by tenant)
       2) Leasing commissions
       3) Capital expenditures (major repairs of: roof, exterior

            walls, common areas, HVAC, parking lot, etc.) 

       4) Acquistion costs (sometimes included)

      

3) End Sale Price (property sale price at end of holding period)

 

         1) Broker commissions expense

         2) End sale price changes related to amount of

             Year X NOI

         3) End sale price inflation or deflation resulting

             from

                 a) subject property's risk changes

                 b) market's shift in required returns of

                     cap rates, yield rates, etc. 

 

Also) Loan debt service and investor's income taxes are excluded.

 

 

 

 

Alternative Cap Rate method

This could be called "Stabilized Cap Rate"

 

 

Stabilized Year 1 NOI        = Stabilized Cap Rate 

            Price 

 

Here "Stabilized Year 1 NOI" could be an average of all years' NOI over a holding period. A 10 year expected holding period would, thus, require the averaging of 10 years of NOI (dollars prior to adjusting for typical NOI growth/inflation).

 

One could also just average, say, the first few years of NOI.

 

 

 

 

Yield, IRR, & Discounted Cash Flows (DCF)

and the math beyond the simple cap rate

 

A Cap Rate is not a consistent measure or fully inclusive measure of return. Yield is the real return. Yield is the average annual real return you expect from purchase to sale - start to finish. This is the all-inclusive consistent measure upon which investment real estate is priced and sold by sophisticated buyers and sellers.

 

Especially for multi-million dollar properties, cap rates are "yield driven" because real return is what is important to sophisticated investors. As an investor, I don't care about the cap rate, I care about the yield!

 

“Yield” is derived by a discounted cash flow mathematical method. Yield Rate is another way of saying IRR - internal rate of return, or MIRR - modified IRR.

 

The Yield Rate captures the changes in future cash flows - whether contractual lease changes or market changes, below-NOI expenses, and the end sale of the property. Below-NOI expenses are capital expenditures, leasing commissions and owner-paid tenant improvement costs. Yield can also capture investor taxes and loan debt service.

 

Fortunately, Yield can be easily calculated with little effort when you use DCF programs such as ModernValue software. This software has different versions including the highest which does powerful calculations for rolling lease assumptions, and more..

 

Although popularly quoted, cap rates are very simple and not an accurate representation of a property's return. Suppose two properties have the exact same yields and level of risk projected over the same holding period. One property could be 8% cap rate priced, and the other 7% cap rate priced. For instance, here, the yields could be the same, but the cap rates different - both are equally profitable! Here, the difference in cap rates is due to differing future NOI cash flows, differing below-NOI expenses, or both.

 

Yield can be calculated without a loan or with a loan in place (Leveraged Yield), and also before or after taxes. A Yield rate is derived after completing a yield analysis with, say, 10 years of estimated cash flows.

 

MIRR - Modified Internal Rate of Return - can be an even more accurate yield measure because it calculates the internal returns at a specific rate. If you estimate a return of, say, 5% on pocketed cash flows that you reinvest during the holding period, and your IRR is different, then use MIRR.

 

Discount Rates are normally referred to as such when one uses a rate, of say 8%, to back into a Present Value. Mathematically, Yield and Discount Rate become equal when the Present Values of each formula are the same.

 

The cap rate used at the end of an investment holding period to calculate the end sale price that terminates the investment is the Terminal Cap Rate or End Sale Cap Rate. The NOI used in the formula is often simply the following year's estimated NOI - which is Year 1 NOI for the new buyer.

 

-- by Stuart Haxton

   ModernValue Software

 

 

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