When investing in a private real estate opportunities, there are few key calculations to quickly evaluate the opportunity to see if it’s a good match for your portfolio.
A property’s capitalization rate (“Cap Rate”) is the ratio of a property’s Net Operating Income (NOI) in the first year of ownership, divided by its purchase price.
Cap Rate =NOI/Price
Since nobody knows what the exact NOI will be in the first year of ownership, the NOI is estimated based on the most recent year’s numbers. In simplest terms, the cap rate is the expected rate of return in the first year of ownership of a commercial property.
For example, a property priced at $1,000,000 with an NOI of $100,000 has a cap rate of 10%. At an annual return rate of 10%, you can expect to recoup 100% of your investment in 10 years, without factoring in inflation.
By working backward, the Cap Rate formula can be used to determine the value of a property – in other words, the price at which an investor would be willing to pay for a property.
In this case, the Cap Rate can be looked at as the expected rate of return.
Price = NOI/Cap Rate
For example, you’re considering a property that currently generates $100,000 in NOI. You expect a return of 10% from this property. The value of that property would be $1,000,000 – the purchase price.
When evaluating an investment into a real estate fund or partnership, the Cap Rate is a quick and easy tool for evaluating the target asset.
The most common use of Cap Rate as an evaluation tool is to compare the Cap Rates of two similar properties in a particular market. The choice between two identical properties on opposite ends of town could come down to Cap Rate. All things being equal, the property with the higher Cap Rate will be the better option.
A reverse formula is also a useful tool for determining whether the seller is asking too little or too much for a property. Keeping with the numbers from the example above. A property is generating $100,000 in NOI, and based on your research; you determine that the Cap Rate should be around 10% based on similar properties in the area.
In other words, the expected return on the property is 10%. Using the reverse formula, we calculate the value as follows:
Value (purchase price) = $100,000/.10
Value (purchase price) = $1,000,000
If the seller is asking $800,000 for a property, then you know you have a bargain on your hands because, based on your valuation, the property is worth $1,000,000. On the flip side, a seller asking $1,200,000 for the property is asking too much.
Cap Rate seems like a decent evaluation tool, but what about value-add opportunities? A 10% Cap Rate is fine and dandy, but you’re confident you can NOI through cost-cutting and rent-increasing measures.
How do you account for an increase in NOI? In your mind, the value-add opportunities increase the value of the property and what you’re willing to pay for it.
Value-add measures can be taken into account through a modified reverse Cap Rate formula, where the Real Cap Rate is a function of (Initial Cap Rate) – (Future Growth Rate of NOI).
The projected property value taking into changes in NOI is then expressed as follows:
Projected Value =
NOI/Real Cap Rate (Initial Cap Rate – Future NOI Growth Rate)
Based on the formula above, a positive growth rate in the NOI should increase the projected property value. In contrast, a decline in NOI should result in a decrease in the projected property value.
According to general risk-return principles, an increase in Cap Rate (i.e., return) corresponds to an increase in risk and a resulting drop in value for undertaking additional risk. On the flip side, a decrease in Cap Rate corresponds to a decrease in risk, and the resulting increase in value for undertaking less risk.
Here’s how it all works. Continuing with our example above, a property generating $100,000 in current NOI with a 10% Initial Cap Rate along with an expected 2% growth in NOI through value-adds increases the projected property value from $1,000,000 to $1,250,000 as a result in the drop in the Real Cap Rate corresponding with a reduction in risk.
Projected Value =
$100,000/(Initial Cap Rate (10%) – Future NOI Growth Rate (2%)Projected Value = $100,000/.08 – $1,200,000
Now let’s take a look at a Class A property with no vacancies and no value-add opportunities. Sticking with the figures above, with an NOI of $100,000 and an Initial Cap Rate of 10%, the value of the Class A property is going to be pretty much fixed since there will be little chance to increase the NOI growth to bump the value.
The value of this formula is that only the buyer knows what the Future NOI Growth Rate is. Only the buyer can predict this growth rate accurately because it’s the buyer that knows the worth of their expertise, experience, processes, and infrastructure that can all be leveraged to increase NOI. This the buyer’s ace in the hole – and can be a valuable negotiation tool.
For example, even though a seller is asking $1,000,000 for a property, it may be worth $1,200,000 to the buyer who is almost certain they can grow NOI by 2%. But the seller doesn’t know this and is negotiating with the buyer with a starting point of $1,000,000, not $1,200,000.
To the buyer, $1,000,000 is already a bargain, but the seller doesn’t know this and would be willing to come down from $1,000,000 as part of the negotiation back and forth, which will all be gravy to the buyer.
This modified Cap Rate formula is also valuable for comparing two properties with different NOI growth rates. Take, for example, two properties with an Initial Cap Rate of 8% and NOI of $100,000.
Initial values for each property would be $1,250,000. However, NOI for Property 1 is expected to grow by 2%, and NOI for Property 2 is expected to decline by 2%. The Real Cap Rates for both properties are as follows:
Property 1 Real Cap Rate = (8%-2%)
Property 2 Real Cap Rate = (8%-(-2%)Property 1 Real Cap Rate = 6%
Property 2 Real Cap Rate = 10%
The projected values for each property, taking into account the change in NOI are as follows:
Property 1 Value = $100,000/.06
Property 2 Value = $100,000/.10Property 1 Value = $1,666,667
Property 2 Value = $1,000,000
Which property would you rather own at the end of the term of an investment? Property 1 or Property 2?
Property 1 obviously since its value has appreciated from the initial purchase price while the value of Property 2 has declined.
The lesson from all this is that you want the Cap Rate to be lower when you sell a property than when you buy the property because that means your property has appreciated in value. One sure way to ensure the Cap Rate is lower at the time of sale is through value-adds that will increase NOI.
When investing in a private real estate fund, you want to make sure you’re investing with a company with the expertise, experience, infrastructure, and processes to grow NOI through value-adds. This will ensure appreciation of your investment.
The companies that understand Cap Rates and how to use them to their advantage when acquiring properties, as discussed in this article, will have a leg up on the competition.
Invest for Success,