Question

How does a projected decline in value and income affect capitalization rates?

Answer 1

The Capitalization Rate, better known as the “Cap Rate”, is one of the most fundamental concepts used in the commercial world of real estate investment.
A cap rate measures a property’s natural rate of return for a single year without taking into account debt on the asset, making it easy to compare the relative value of one property to another.
It is used to estimate the investor's potential return on their investment in the real estate market.

When trying to decide whether a real estate investment is a good deal, the investor tries to find out what cash flow does the property generate. The answer to this query depends on each individual buyer’s circumstances. That’s why cash flow may not be a good metric to value an investment. For example, one investor might have a higher interest rate on his loan, which in turn increases his payments & that could result in a negative cash flow. Another investor may have a lower interest rate resulting in lower payments & thus he may be able to generate positive cash flow. Other factors, such as loan amortization or tax brackets, will also affect owners differently. That is why “cash-on-cash return” or “total return” may likewise present ambiguous indicators of a property’s value.

Hence, real estate professionals use cap rates. The purpose of cap rates is to create a measure that can be used to compare properties on a level playing field independent of a buyer’s situation. In order to mitigate debt related issues, when using cap rates, it is assumed that the property is an all cash purchase.

While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.

How is a cap rate calculated?
A cap rate has two main components: (1) net operating income (“NOI”); and (2) the estimated value of the property.
The capitalization rate of a real estate investment is calculated by dividing the property's net operating income (NOI) by the current market value. Mathematically,
Capitalization Rate = Net Operating Income / Current Market Value

where, the net operating income is the (expected) annual income generated by the property (like rentals) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include the cost paid towards the regular upkeep of the facility as well as the property taxes. Mortgage payments and depreciation are not considered operating expenses, so the NOI is essentially the net income that one might realize if the property has been bought for all cash.
NOI consists almost entirely of rent payments,which for most property types derive from long-term lease contracts.
The current market value of the asset is the present-day value of the property as per the prevailing market rates.

What’s a good cap rate? It depends on how one is using the cap rate. For example, if he is selling a property then a lower cap rate is good because it means the value of the property will be higher. On the other hand, if the property is to be bought then a higher cap rate is good since the initial investment/ the purchase value will be lower.

Effect of NOI & Current market Value of the property on the Capitalization Rate

For example :-

Lets assume that an investor has $1 million and he is considering investing in one of the two available investment options i.e. 1) he can invest in government-issued treasury bonds that offer a nominal 3% annual interest and are considered to be risk-free and 2) he can purchase a commercial building that has multiple tenants who are expected to pay regular rent.

In the second case, suppose the total rent received is $90,000 per year and the investor needs to pay a total of $20,000 towards various maintenance costs and property taxes. Hence, the net operating income from the property investment is $70,000. Assume during the first year, the property value remains steady at the original buy price of $1 million.

The capitalization rate will then be (Net Operating Income/Property Value) = $70,000/$1 million = 0.07 = 7%.

This return of 7% generated from the property investment is better than the standard return of 3% from the risk-free treasury bonds. The extra 4% represents the return for the risk taken by the investor by investing in the property market as against investing in the zero risk treasury bond.
Property investment is generally risky, and there can be several circumstances when the return, as represented by the capitalization rate measure, can vary widely.
For instance, a few of the tenants may move out and the rental income from the property may diminish to $40,000. Assuming that all the other values remaining same, the capitalization rate comes to ($20,000 / $1 million) = 2%. {NOI = $40000-$20000= $20000}. This return is less than that from risk-free bonds.

In another scenario, assume that the rental income stays at the original $90,000, but the maintenance cost and/or the property tax increases significantly, to say $50,000. {NOI = $90000-$50000= $40000}. The capitalization rate will then be ($40,000/$1 million) = 4%.

In another case, if the current market value of the property itself diminishes, to say $800,000, with the rental income and various costs remaining the same, the capitalization rate will increase to ($70,000/$800,000) = 8.75%.

Hence, we can see from the above hypothetical example that, varying levels of income that gets generated from the property, expenses related to the property and the current market valuation of the property can significantly change the capitalization rate.

Cap rates are influenced by many factors such as the health of the economy, interest rates, interest rate expectations, vacancy rates, property type (industrial vs. multi-family), geographical area (New York vs. Los Angeles), or property class in the same city (Class A vs. Class B), creditworthiness of the tenants, diversity of the tenants, length of tenant leases in place.

The cap rate of a property will fluctuate if either the NOI or value changes. Since a property’s value can be impacted by many outside forces such as market demand or interest rates, the cap rate for a single property may go up or down even if there is no physical change to the amount of income (NOI) produced.
The projected value in any given year (i.e., the "present value" in that year) is equal to the expected NOI divided by the investor's required capitalization rate.
When someone buys a property with the expectation that its NOI will representa return on his investment. It is reasonable to assume that whoever buys the property from him/her in the future will have a similar expectation. That new investor will probably be willing to purchase the property at a price that allows it to yield his or her desired rate of return (i.e., capitalization rate). Hence, we can conclude that, capitalization rate is a predictor of future value of a property.However, the assumptions regarding future years' income and expenses have to be realistic.

Since cap rates are based on the projected estimates of the future income, they are subject to high variance. Different cap rates among different properties, or across different time horizons on the same property, represent different levels of risk. The cap rate value will be higher for properties that generate higher net operating income and have a lower valuation, and vice versa.
Lets say, there are two properties at 2 different places that are similar in all attributes. One is in a posh area while the other is on the outskirts of the city. All things being equal, the first property will generate a higher rental compared to the second one, but those will be partially offset by the higher cost of maintenance and higher taxes. The posh property will have a relatively lower cap rate compared to the second one owing to its significantly high market value.

It indicates that a lower value of cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.