Jansen Multifamily Team Blog

This post is the first in a new series on the fundamentals of commercial real estate investing.  With each new post, JMT will discuss a new concept and explain how it is used by the Team to analyze any investment opportunity.

One rarely discusses a commercial real estate investment without hearing about cap rates.  In the simplest terms, cap (short for capitalization) rates represent a property’s annual rate of return.  To derive a cap rate for a new investment, simply divide the property’s first-year Net Operating Income (NOI) by the Purchase Price; this represents the property’s unleveraged rate of return in the first year.

Cap rates serve several important purposes.  First, cap rates allow investors to compare average rates of return across different properties and asset classes.  Investments inherently have different levels of risk for a variety of reasons, including vintage or location, and therefore require different rates of return.  Generally speaking, the riskier the investment, the higher the required return will be.  This principle explains why cap rates are lower in newer, better-located properties; the income stream is less risky, therefore the rate of return is lower.  Additionally, office and retail properties are perceived to be riskier that multifamily properties; therefore, cap rates are higher for office and retail investments.

Cap rates also allow for a quick valuation of a property.  Simply calculate the property’s NOI by subtracting all operating expenses from collected income, then divide by a “market” cap rate.  Of course, there are many intricacies to property valuation that go beyond simple income capitalization, such as a study of rent and sales comparables, analysis of operating expenses, and detailed return projections.  For this reason, when making real estate decisions, it is important to seek out a professional Advisor that will provide an informed and unbiased opinion of value that is rooted in knowledge of the market and investor expectations, not baseless assumptions.

It is important to remember that cap rates illustrate only an unleveraged rate of return for a property.  It is rare that a commercial real estate investment is purchased without some degree of debt financing, therefore the property’s cap rate may not be the actual rate of return realized by the investor.  Generally speaking, leverage will drive stronger returns with positive financial leverage, which is when the acquisition cap rate is higher than the interest rate on the debt.  When underwriting returns, JMT performs a 10-year discounted cash flow analysis to drill down to more sophisticated return metrics like average cash-on-cash return and internal rate of return (these terms will be covered in future posts).

Cap rates illustrate the important relationship between income and value.  This simple rate of return allows investors to decide what they are willing to pay for an asset, given the risk profile of the investment.  Further, cap rates help reveal trends in the market based on investors’ required rates of return for acquisitions.  While cap rates have their limitations, such as excluding the effect of leverage, they are the fundamental starting point for analyzing commercial real estate investments and should be understood by anyone interested in real estate investing.