In the world of corporate finance and valuation multiples are a familiar concept. As I have discussed in several past posts, multiples give an idea of relative valuation or what others are willing to pay for an asset. Over the weekend, I was home visiting my family and was discussing corporate finance concepts with my father, who is does real estate valuation for a living and he explained to me a similar concept. In real estate, the analogous concept would be the capitalization rate, or cap rate for short. I thought it would be interesting to explore this concept further in a blog post for an asset class (real estate) that I am not as familiar with as equities.
By definition a Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. Essentially, the cap rate is the inverse of traditional corporate finance multiples where the price is the numerator and the earnings are the denominator, so it is expressed a percentage. They can also been seen as a quick approximation of a property’s yield. An investment property, i.e., one that generates rental income, is viewed in the context of its net income which is rental revenue less operating expenses. This net operating income would be akin to an EBITDA in the corporate finance world. To derive the value of a commercial property, its net operating income is divided by a market cap rate, or a rate of return prevalent in the market, to arrive at a value one might pay for the benefits (cash flow) of that particular asset.
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. For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs is subtracted from gross lease income) during one year, then the indicated cap rate would be 10%:
$100,000 / $1,000,000 = 0.10 = 10%
Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized – or pay for itself – after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years.
Another way cap rates can be helpful is when they form a trend. If you’re looking at cap rate trends over the past few years in a particular sub-market then the trend can give you an indication of where that market is headed. For instance, if cap rates are compressing that means values are being bid up and a market is heating up. According to the Wall Street Journal’s Property Pulse, cap rates for office buildings fell from 7.15% in 2012 to 6.93% in 2013. Cap rates are market based and fluctuate with the ups and downs of the commercial real estate markets. Although they have some similarity to multiples in the corporate valuation sense, cap rates represent a very different asset class – commercial real estate – and are driven by very different factors over time. Overall, they are a useful tool to understand for anyone planning to invest in real estate.