Thursday, September 15, 2011

CAP RATES: Do they provide an accurate picture of what is the real return to an investor?

Written By:
Dave DiCenso
Investment Sales For RCRS

In the following summary of my research on this topic I am not inferring that a Cap Rate is not to be used, but more so let the “investor beware.”  A Cap Rate is not the entire picture of the success of an investment; rather it is a quick and simple formula to estimate a future expectation. 

Cap Rate Definition - Commercial Real Estate à    Year 1  NOI      = Cap Rate

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 purposely simple Cap Rate math.

 The Cap Rate formula excludes these applicable items:

 Changes in cash flows after Year 1

2) "Below NOI expenses":

1)      Tenant improvement costs (those not paid by tenant
2)      Leasing commissions
3)      Capital expenses (major repairs of roof, HVAC, parking lot, structure, etc.) 
3) Loan expenses

1)      Financing costs- points, interest &fees or costs incurred by leveraging the property during the holding period

4) Reversion Price (property sale price at end of holding period)

1)      Broker commissions expense
2)      Reversion sale price changes related to amount of reversion in Year X NOI    (X is Year 11 if sold in year 10)
3)      Reversion sale price inflation or deflation resulting from
1)      Subject property's risk changes
2)      Market's shift in required returns (cap rates, yield rates, etc.) 

 Alternative method -   “Total Cap Rate” à  Stabilized Year 1 Net Income   = Total Cap Rate

This formula could include all of the figures above; however, determining the amounts may be complex (especially for TIs, LCs and Loan payments) and, thus, require a yield analysis over an assumed holding period.

“Yield” is the real return. Cap Rates are "yield driven" because real return is what is important to knowledgeable investors. As an investor, I don't care about the cap rate - I care about the yield!

For example, if the yields and risks are projected to be the same, over the same holding period, a 7% cap priced property can be equivalent to a 6% cap priced property. The difference is because of different expenses below-NOI.


 A Cap Rate is not a dependable measure or fully comprehensive measure of return like Yield. Yield is the real return. "Expected 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 by expert buyers and sellers. Yield may be calculated with or without leverage - a loan in place (i.e. Leveraged Yield or Non-Leveraged Yield). The alternative method called “Total Cap Rate” is very close to yield in accuracy and significance.

Footnote - article points contributed from Stuart Haxton Co. Investment RE Marketing Consulting