The cap rate is the rate of return on a real estate investment property based on the expected income that the property will generate. It is a key metric that represents an investor’s expected return on investment. This is derived by dividing the net income the property will generate by the total market value of the property. For example, a building with a $400,000 of net income that cost $10 million to purchase will have a 4% cap rate.
Cap Rate = NOI / Value of the property
- When acquiring an income property, the higher the cap rate the better
- When selling the income property, the lower the cap rate the better
- A higher cap rate implies a lower price, and a lower cap implies a higher price
It is important to distinguish the difference between the cap rates throughout underwriting the deal:
The entry cap rate represents the value of the property at the time of the purchase of the property. This cap rate is based on existing rates, vacancy, etc at the purchase. For a buyer to fully calculate the cap rate, you need to have the operating income, and operating expenses.
The in-place cap rate is based on the stabilized value of the property after repairs have been completed, rents have been increased, RUBS has been implemented, etc. This rate is based on the assumptions the buyer comes up with after running their estimated numbers based on your business plan.
The reversion cap or exit cap rate represents the relationship between NOI and the price at the time of the sale of the property. The exit cap is calculated by taking the expected net operating income divided by the projected sale of the property. This rate is estimated based on the comparable transaction data and market conditions. In general, the proforma assumes the NOI will grow steadily over time due to market rents, RUBS, a decrease in expenses, etc. Although the entry cap rate provides a reference point, it’s best to be conservative in your underwriting. The rule of thumb when underwriting the reversion cap is to conservatively add +10bps per year from the market cap rate. If the market warrants a 4% cap rate and you estimate a 5-year holding period, you will underwrite your exit cap at 4.5%. It’s also helpful to consider a range of cap rates to calculate the returns in any given scenario:
With the increase in your NOI at the exit sale, the low cap rate benefits you making your sale price even higher and therefore bringing you a profitable investment. Understanding the different types of cap rates are vital to assessing a property’s profitability and return potential.
Example of all three cap rates:
Let’s say you purchased a property for $10 million dollars that had a net operating income of 400k. This would put us at a 4% going-in cap rate.
Entry:
$400,000 / $10,000,000 = 0.04 - 4% cap rate
Now let’s say you add $100k of value to the property through rent increases, RUBS etc.
In-Place:
$500,000 / $10,000,000 = 0.05 = 5% cap rate (your in-place cap rate once the property has been stabilized) Let’s say the market is warranting a 4% cap rate.
Exit Cap Rate:
$500,000 / 0.04 = $12,500,000
Therefore giving you a $2.5 million in profit by adding $100k of value to the property.
