Cap Rate Definition

Cap Rate Definition

A real-world definition of the commercial real estate Cap Rate

plus, DCF, Yield, and IRR explained.

Cap Rate

Year 1 NOI = Cap Rate

PRICE

A Cap Rate is simply the rate of Year 1 Expected Net Operating Income / Price. Future expectations - beyond Year 1 are not mathematically involved in the intentionally-simple Cap Rate math.

The Cap Rate formula excludes these relevant items:

1) Changes in cash flows after Year 1

1) Known changes - like lease expirations
2) Unknown changes - like market vacancy and inflation

2) "Below NOI expenses"

       1) Tenant improvement costs (those not paid by tenant)
       2) Leasing commissions
       3) Capital expenditures (major repairs of: roof, exterior

walls, common areas, HVAC, parking lot, etc.)

3) End Sale Price (property sale price at end of holding period)

1) Broker commissions expense

2) End sale price changes related to amount of

Year X NOI

3) End sale price inflation or deflation resulting

from

a) subject property's risk changes

b) market's shift in required returns of

cap rates, yield rates, etc.

Also) Loan debt service and investor's income taxes are excluded.

Alternative Cap Rate method

This could be called "Stabilized Cap Rate"

Stabilized Year 1 NOI = Stabilized Cap Rate

Price

Here "Stabilized Year 1 NOI" could be an average of all years' NOI over a holding period. A 10 year expected holding period would, thus, require the averaging of 10 years of NOI (dollars prior to adjusting for typical NOI growth/inflation).

One could also just average the first few unstable years' NOI.

Yield, IRR, & Discounted Cash Flows (DCF)

and the math beyond the simple cap rate

A Cap Rate is not a consistent measure or fully inclusive measure of return. Yield is the real return. Yield is the average annual real return you expect from purchase to sale - start to finish. This is the all-inclusive consistent measure upon which investment real estate is priced and sold by sophisticated buyers and sellers.

Cap rates are "yield driven" because real return is what is important to sophisticated investors. As an investor, I don't care about the cap rate, I care about the yield!

“Yield” is derived by a discounted cash flow analysis. Yield Rate and IRR - internal rate of return - are often meant to be the same.

The Yield Rate captures the changes in future cash flows - whether contractual changes or market changes, below-NOI expenses, and the end sale of the property. Below-NOI expenses are capital expenditures, leasing commissions and owner-paid tenant improvements. Yield can also capture investor taxes and loan debt service.

Fortunately, Yield can be easily calculated with little effort when you use DCF programs such as ModernValue software. This software has different versions including the highest which does powerful Argus-like calculations for rolling lease assumptions, etc.

Although popularly quoted, cap rates are very simple and not an accurate representation of a property's return. Suppose two properties have the exact same yields and level of risk projected over the same holding period. One property could be 8% cap rate priced, and the other 7% cap rate priced. Here, the yields are the same, but the cap rates are different. Both are equally profitable! Here, the difference in cap rates is due to differing future cash flows, differing below-NOI expenses, or both.

Yield can be calculated without a loan or with a loan in place (Leveraged Yield), and also before or after taxes. A Yield rate is derived after completing a yield analysis with, say, 10 years of estimated cash flows.

MIRR - Modified Internal Rate of Return - can be an even more accurate yield measure because it calculates the internal returns at a specific rate. If you estimate a return of, say, 7% on cash flows that you reinvest during the holding period, and your IRR is different, then use MIRR.

Discount Rates are normally referred to as such when one uses a rate, of say 10%, to back into a Present Value. The Yield of a property is also referred to as the Discount Rate.

The cap rate used at the end of an investment holding period to calculate the end sale price that terminates the investment is the Terminal Cap Rate. The NOI used in the formula is often simply the following year's estimated NOI, which is Year 1 NOI for the new buyer.

-- by Stuart Haxton

Other resources:

investing-101-what-is-internal-rate-of-return-irr

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