Cap rates are the most commonly used method to value commercial real estate. Simply put, a cap rate (or capitalization rate) is the NOI divided by the property (sale) value. As mentioned in the previous article, it’s probably easiest to think of NOI as EBITDA (revenue minus expenses, before debt) as the two metrics are very similar.
Cap rates mirror every other (risk-reward) return profile in that they measure the riskiness of a particular asset. Within real estate, each asset-class has a different risk-reward profile and therefore, some assets are designated as riskier than others (the riskier the asset, the higher the cap rate). Hotels are the riskiest, followed by office and then multifamily. This is evidenced by the cap rates investors assign to each respective asset class.
As a side note, although the unlevered (pre-debt) return can change during the hold period, this is not typically referred to as a cap rate, rather it is referred to as the “yield”. Only the entry and exit yields are typically referred to as “cap rates”.
Ideally, real estate investors make their money in 3 primary ways.
The first is off the yield from the initial cap rate (ex. If the cap rate is 7%, investors get a 7% return).
The second is off juicing this initial cap rate with debt. Say you buy at a 7% cap rate (your money is getting a 7% return) and you borrow at a 4% interest rate. Now, not only are you making money off the initial return, but you’re juicing that return by leveraging the spread between the interest rate and the cap rate. The magnitude of this is obviously dependent on the amount of leverage used.
The third way is through cap rate compression. Essentially, you want cap rates to compress or decrease over your hold period. Why is this? It’s probably easiest to think about it conceptually.
Conceptually, when you sell for a lower cap rate than you bought for, it means that someone else is accepting a lower rate of return than you did. In order for them to accept a lower rate of return, something must have changed (improved) at the property to make it less risky – either you added value, market conditions improved, or something of the sort.
A different way of thinking about this is by recognizing that a cap rate is simply the inverse of an EBITDA multiple. Those of you in the regular private equity world may be familiar with the EBITDA multiple valuation method, in which a company sells for ‘x’ times EBITDA. Imagine that you bought an asset for 5x EBITDA and then sold it for 10x EBITDA. That would be a pretty incredible return, right? The effect of buying at a 5x EBITDA multiple and selling at a 10x EBITDA multiple is very similar to buying at a 10% cap rate and selling at a 5% cap rate. Just to illustrate this point, ideally, you’d want to buy at an infinity cap rate and sell at a 1% cap rate.
This is why market cycles are so important in real estate. When you buy at the top of the cycle, you’re buying at a low cap rate (let’s say 4.5%). If you buy at a 4.5%, there is essentially no room for cap rates to compress, because the lowest they can really go is 0% (unless the next buyer is willing to accept a negative rate of return). But, that’s not factoring in the cost of debt (almost everyone is going to use debt to juice their returns, so the market factors in the cost of debt into the purchase price). Banks aren’t going to just loan you money for free. So let’s say banks are willing to loan you money at a 4% interest rate. Now… you really have nowhere to go at this point but up as there is only a 50 basis point spread between the interest rate and your return. Since most buyers do not want negative leverage (although in some value-add scenarios, buyers are willing to accept negative leverage for a short amount of time), cap rates will only decrease if the fed lowers interest rates. But… what happens if the fed raises rates instead? If the fed raises rates, to 4.5%, then cap rates will very likely increase to 5% so that the spread between interest rates and cap rates persists and investors can make money. And that is where the danger begins. Just like buying at a high cap and selling at a low cap is a boon to your returns, buying at a low cap and selling at a high cap is disastrous. For arguments sake, let’s say you end up waiting to sell and selling at the bottom at a 7% cap rate. At an NOI of $100, that would mean you bought at $100/4.5% = $2,222 and sold at $100/7% = $1,429. You’ve lost over a third of your capital. Not pretty.
Now let’s imagine the reverse scenario: you buy after the market crashes. In this scenario, you’re buying at a high cap rate (say 7%) and selling at a low cap rate (say 4.5%). If you buy at a 7% cap rate, now you actually have some room to compress downwards. At an NOI of $100, that would mean you bought at $1,429 and sold at $2,222. Instead of losing 1/3 of your capital as in the previous scenario, you’ve achieved over a 50% return. That’s how powerful the effect of cap rates is.
Notice that in both scenarios, the NOI didn’t even change – all that changed was the cap rate, which made the returns drastically different.
The two scenarios above illustrate why you should never trust the ‘incredible returns’ of a sponsor who has not been through a recession. Even a blabbering moron could have made money with a fund that was started in 2010. Don’t believe me? Check the average returns of a vintage 2010 fund. Now compare that to the average returns of a vintage 2006 fund. They won’t even be comparable. Unlike in the stock market, you can’t “short” your real estate investment. There are very few ways to make your investment counter-cyclical. If you invest at the wrong time, you simply lose.
Here’s what no one wants to tell you – the biggest part of being a good real estate investor is not your actual deal-by-deal investment thesis, but rather your ability to time markets.
Timing the market – blood on the streets…