Sunday, January 3, 2016

Understanding Cap Rates

The easiest and most commonly used method of valuing a property is the cap rate method. I'd say it's really more of a back of the envelope type of calculation you do at the beginning of the analysis process to get a ballpark figure, but the industry puts a lot of weight on this method. So what exactly is a cap rate?

Cap Rate Valuation Method

Calculating a cap rate is actually pretty simple. It's just the property's net operating income / the purchase price. If you pay $10M for a property and the NOI is $1M, then the cap rate is calculated as 1 / 10 = 10%.

You can then rearrange the equation so that Purchase Price = NOI / Cap Rate. If you know a property's NOI and what the market cap rate is, then you can calculate what the purchase price should be. For example, If a property's NOI is $1M and you believe properties trade at a 5% cap rate in that market, then the implied value of the property is 1 / .05 = $20M.

Without getting too finance nerdy, the cap rate valuation methodology is equivalent to the perpetual annuity value formula (Annuity Value = Annuity Payment / (Discount Rate - Perpetual Growth Rate)). NOI is equivalent to the annuity payment and the cap rate is equal to the discount rate - the perpetual growth rate. If a market cap rate is 5%, then 5% = Some Discount Rate - Some Perpetual Growth Rate.

This last point is important to understand because it shows how market cap rates can fluctuate--either through changes in the perceived market growth rate or the discount rate. Take two markets such as San Francisco and Bakersfield. San Francisco is a high growth area with a supply-constrained real estate market. Bakersfield is a low growth area with a lot of land that could be built on. It's fair to assume that San Francisco properties will experience much higher demand and rent growth, implying a much higher perpetual growth rate, than Bakersfield, which could partly explain why San Francisco has much lower cap rates than Bakersfield.

In a simplified equation, a Discount Rate = Risk Free Rate + Risk Premium. Think of the risk free rate as the interest rate on a government bond. Each property will then have some sort of risk premium over the risk free rate. Reusing the SF and Bakersfield examples, SF might have a much lower risk premium because it's a top tier market. Bakersfield, on the other hand, is a tertiary market and might have a much higher perceived risk associated with it. The lower risk SF market will have a lower risk premium and, subsequently, lower discount rate, driving down the cap rate further in SF.

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