![]() ![]() This means you could invest all $10,000,000 into treasuries, considered a very safe investment, and spend your days at the beach collecting checks. Suppose you have $10,000,000 to invest, and 10-year treasury bonds are yielding 3% annually. How can we use this concept to determine cap rates? Treasury bond is normally used as the risk-free rate. bonds are considered to be very safe, the interest rate on a U.S. Of course, in practice, all investments carry even a small amount of risk. In finance, the risk-free rate is the theoretical rate of return of an investment with no risk of financial loss. What are the components of the cap rate, and how can they be determined? One way to think about the cap rate is that it’s a function of the risk-free rate of return plus some risk premium. However, if the property’s net operating income stream is complex and irregular, with substantial variations in cash flow, only a full discounted cash flow analysis will yield a credible and reliable valuation. When properly applied to a stabilized Net Operating Income (NOI) projection, the simple cap rate can produce a valuation approximately equal to what could be generated using a more complex discounted cash flow (DCF) analysis. While cap rates are useful for quick back of the envelope calculations, it is important to note when cap rates should not be used. Where are values likely to go next year? Looking at historical cap rate data can quickly give you insight into the direction of valuations. ![]() For instance, if cap rates are compressing, that means values are being bid up and a market is heating up. If you’re looking at cap rate trends over the past few years in a particular submarket, then the trend can give you an indication of where that market is headed. A 5% cap rate acquisition versus a 10% cap rate acquisition for a similar property in a similar location should immediately tell you that one property has a higher risk premium than the other.Īnother way cap rates can be helpful is when they form a trend. For example, it can and often is used to quickly size up an acquisition relative to other potential investment properties. The cap rate is a very common and useful ratio in the commercial real estate industry, and it can be helpful in several scenarios. A bad cap rate would be one derived from different property types in different markets. In this case, a good cap rate is one that is derived from recent office building sales in the same market. For example, suppose you want to figure out what an office building is worth based on a market-derived cap rate. In this case, a good cap rate is one that is derived from similar properties in the same location. You might also be trying to find a market-based cap rate using recent sales of comparable properties. On the other hand, if you are buying a property then a higher cap rate is good because it means your initial investment will be lower. For example, if you are selling a property, then a lower cap rate is good because it means the value of your property will be higher. What’s a good cap rate? The short answer is that it depends on how you are using the cap rate. In other words, as the cap rate goes up, the NOI multiple goes down. Consider the following chart:Īs shown above, cap rates and NOI multiples are inversely related. For example, a 5% cap rate results in a value of 1/.05 or 20x NOI. To find the NOI multiple for a particular cap rate, just divide 1 by the cap rate. ![]() In the above example, assuming the real estate proforma is accurate, an all-cash investment of $17,000,000 would produce an annual return on investment of 5.8%.Īnother way to think about the cap rate is that it’s just the inverse of the price/earnings multiple. What is the cap rate actually telling you? One way to think about the cap rate intuitively is that it represents the percentage return an investor would receive on an all cash purchase. If an appraiser derives a market-based cap rate of 6% for our market, then we can divide our $900,000 NOI by 6% to estimate a market value of $15,000,000. Suppose our Class A office building generates a stabilized NOI of $900,000, and we want to know what the building is worth. To estimate the market value for a property, an appraiser might use several recent sales like this to derive a market-based cap rate for Class A office buildings. In the commercial real estate industry, it is common to say that this property sold at a 5.8% cap rate. ![]() Suppose we are researching the recent sale of a Class A office building with a stabilized Net Operating Income (NOI) of $1,000,000, and a sale price of $17,000,000. Let’s take an example of how a cap rate is commonly used. Appraisers frequently use this relationship to estimate the market value for a property based on a cap rate derived from comparable sales. ![]()
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