Cap Rates - Wicked Simple or Wicked Complicated?

Are cap rates wicked simple or wicked complicated? The snarky answer is “Yes.” What we mean is cap rates have an “everyday” application that is intuitive and simple. Its foundation, however, is much more complicated. As you move toward a career in a real estate private equity firm, you will need to learn to use cap rates in their simple form. But it never hurts to understand the origins of the concept.

 

What is a Cap Rate?

To begin, the term “cap rate” is shorthand for “capitalization rate.” The term is well-defined in real estate appraisals, and is aimed at determining a market rate of return for the property being appraised (see more on appraisals here). The appraisal breaks the cap rate down into three component parts: the risk free rate, the equity rate, and the debt rate. The sum of these three rates becomes the capitalization rate used to arrive at the property value based on the income approach (specifically, net operating income divided by the cap rate equals the property value).

 

So, I have to figure out all of that?

No, that’s the complicated part. The little formula that the appraiser uses is really the shorthand that you need to know: NOI / Cap Rate = Value. Appraisers go through the longer process to arrive at an independent determination of the cap rate, but as a REPE professional, the shorthand is what needs to become second nature. You can practice using cap rates with our real estate investment analysis online course.

Keeping it Simple

Further, the simple way to think about a cap rate is that it represents the unlevered return for an investment. If you flip the formula around, you have NOI / property value = cap rate. Now the focus is on the resulting cap rate, and that cap rate becomes the shorthand that allows you to compare one property to another. You’ll hear conversations around the office like this: “Can you believe they bought that apartment complex at a 6-cap? They stole it!” Or, “That guy is asking for a four-and-a-half cap on a freestanding McDonalds–apparently he doesn’t really want to sell it.”

Cap rates can vary widely across investment strategies (discussed in detail here), across property types (discussed in detail here), and across geography. It will take some time for these nuances to become second nature, but the formula itself should be intuitive. You should also be able to do the math in your head very quickly. More than likely, this will be critical in a job interview. For example, you may be asked what a property is worth if it has NOI of $2,000,000 and trades (sells) at a 5-cap. Forty million should come out of your mouth before you really even think about it (twenty divided by 5). If the thought of this intimidates you, you should strongly consider our real estate investment analysis online courses for practice!

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