The capitalization, or “cap” rate is a term that is used frequently when discussing real estate asset sales and purchases. The cap rate is a ratio of two variables – net operating income and the current value or sale price of a property – which helps to determine the potential return on an investment.
Put another way, the cap rate is the rate at which the net operating income recapitalizes the asset value on an annual basis.
Capitalization Rate = Net Operating Income (NOI) / Current Market Value (or Sale Price)
For example, if an investor buys a retail property in the UK with an annual NOI of GBP 500,000 for GBP 10 million, the cap rate is 5%
Cap rates are used in various ways when analysing real estate investments. Investment groups use cap rates internally to compare and contrast investment opportunities. For example, an investor can spend that GBP 20 million to buy a London apartment building at a 5% cap rate. Or, he may consider spending GBP 14 million to buy a shopping center in Liverpool at a 7% cap rate and the remaining GBP 6 million to buy an industrial building in Manchester at a 6.5% cap. There are a number of other factors that go into those real estate decisions, but on a purely numbers basis, the investor can weigh the pros and cons of buying one asset in a top market that will deliver a 5% return, or buy two different assets in smaller cities with a higher blended return of 6.85%.
While cap rates are a good metric to compare and contrast different investment opportunities, as well as a good measure of market trends it is important to note that not everyone calculates NOI in the same way. Some investors use 12-month trailing income while others will make assumptions based on predictions of higher income in the next 12 months. This is referred to as trailing vs. forward-looking cap rates. Altering these assumptions can produce radically different cap rate results. In some respects, this discrepancy partially explains why investors are willing to pay very low cap rates of below 4%. When accepting a sub 4% cap rate, the investor is less focused on the trailing cap rate and, instead, is targeting a substantially higher forward-looking cap rate. That investor has likely underwritten the acquisition with an expectation that they can boost NOI by raising rents or lease current vacancies. This future improved cap rate is referred to as the “stabilised cap rate”.
Conversely, the purchase price may not be a direct reflection of the NOI that supports it. Suppose a suburban office building requires significant capital improvements. That office building might sell for a lower price since the next buyer will need to invest a large sum into those capital improvements upon acquisition simply to retain the current tenants at current rents (rather than improve the property to increase rents). In that scenario, a higher cap rate is justified compared to a similarly situated office that does not have major deferred maintenance issues even if the NOI is the same for each.
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