A Real Estate Investor’s Quick Guide to Understanding Cap Rates

THE WESTMOUNT INSIDER Presents:

A Real Estate Investor’s Quick Guide to Understanding Cap Rates

Reid Thompson, Sr. Associate – Multifamily Acquisitions, shares insight into real estate’s holy grail as he reviews one of the most important numbers in assessing a successful income producing asset – the crucial cap rate.

When assessing real estate investment deals, a major indicator and key to success is found in the capitalization rate, or as more commonly deemed, the cap rate. Even if you are new to real estate investing, you have probably come to hear this principal key metric term associated with the forecast that is used in determining the ROI from the property. So how do you decide if your potential asset is a possible pitfall or full out home run? Easy: it starts with the cap rate.

1.????Cap Rates Explained: Why is it so important?

A cap rate indicates how much income a property generates relative to the property’s value. In other words, it is the discount rate bridging an asset’s NOI to its value. Real estate investments are complex, but because cap rates are calculated exclusive of debt or interest rate considerations, a cap rate allows investors to quickly compare investment opportunities in the market. They are most useful when comparing similar assets within the same market (or submarket), but they are also instructive when comparing different asset types or like-assets in different markets. Additionally, cap rates are a helpful metric to monitor throughout the hold period as they indicate how much your property can be sold for at any given moment in time.

2.????How do you calculate a cap rate?

• Cap Rate = Net Operating Income / Current Market Value

For real estate investors, NOI is typically derived by taking trailing income and expenses and adjusting for significant changes at takeover like property taxes and insurance. Trailing 1-month or 3-month income is often used to generate something closer to expected income over a forward-looking year. Like any basic math equation, any of the three variables can be solved for with knowledge of the other two. The cap rate formula highlights the importance of income in commercial property valuations and shows how current market value is always in flux.

3.????Understanding and factors affecting cap rates?

In a healthy real estate market, cap rates should indicate the inherent risk of a potential transaction. An investment in a property in a strong urban submarket (with numerous employment bases, higher rents, less land for new supply, and more demand) should be less risky than an investment in the same property located in a tertiary market. Thus, investors should be willing to pay more for the less risky investment, and we would expect the cap rate on the less risky investment to be lower. Urban vs. Tertiary can be replaced by other factors like property type (Class A vs. Class C, for example) or property vintage. In both of these cases, we would still expect the less risky investment to have the lower cap rate and higher market value. Because cap rates are calculated using a property’s NOI (which is always in flux), they are subject to significant variance. Holding market value constant, any change in income or expense assumptions in your calculation of NOI can dramatically affect your cap rate.?? ????

4.????What is a good or bad cap rate? Cap rate comparisons

Because the cap rate can be viewed as a measure of risk, the definition of a good or bad cap rate will depend on the risk profile of the investor. As mentioned above, factors like property type, property age, and property location will all drive expectations on what a good cap rate should be. Ultimately, a good cap rate is dependent on the return you are trying to achieve and the risk you are willing to take to secure it.

5.????Which Cap Rate Is Better: High Or Low?

Because a higher cap rate translates to either higher NOI or a lower purchase price (or both), it is often thought that a higher cap rate is better, at least from the perspective of the buyer. Generally speaking, if you are a buyer, you want a higher cap rate, and if you are a seller, you want a lower cap rate. However, understanding why a cap rate is high or low is ultimately what is important when evaluating an investment opportunity. Because a cap rate is a snapshot of a moment in time, it does not show how a property will perform over several years. A historically strong or poor year could result in a cap rate that misleads how the property will perform over time. As mentioned above, a cap rate is a measure of risk, and whether you pursue a high or low cap rate opportunity will depend on your personal investment criteria and preferences.??

What does this mean for the market status today, you ask? Well according to CBRE’s capital insights reports, “Investment activity in 2022 is expected to top pre-pandemic highs and cap rates will remain stable or slightly compress amid strong investor demand and abundant capital—even as interest rates rise.” It’s important to know that cap rate compression is a phenomenon that happens when the general market believes prices will continue to rise. Or the property NOI is growing faster than inflation such as the current environment. In basic terms, this means that investors are willing to pay more (higher market value) for the same property. Because cap rates and property values are inversely related, if the rate of the market value increases faster than NOI, cap rates will decrease.

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Author: Reid Thompson

Reid is the Sr. Associate – Multifamily Acquisitions at Westmount Capital Realty, LLC. Reid works in Dallas with the multifamily acquisition group at Westmount, covering markets throughout Texas and the West & Southeast regions of the U.S. Reid came to Westmount from the debt side of the industry where he worked in the special servicing division of KeyBank’s Real Estate Capital group. He graduated from the University of Texas at Austin with a bachelor’s in economics.

To learn more about Westmount Realty Capital or for additional information, contact us at [email protected] or find us at https://westmountrc.com/.

This article, and Westmount Realty Capital blogs in general, is intended for informational and educational purposes only, and does not constitute a solicitation or offer by Westmount Realty Capital, LLC to buy or sell any securities, futures, options, foreign exchange or other financial instrument or to provide any investment advice or service. Westmount is not your advisor or agent. Please consult your own experts for advice in these areas. Although Westmount provides information it believes to be accurate, Westmount makes no representations or warranties about the accuracy or completeness of the information contained on this article.