It can be challenging for commercial real estate investors to decide which opportunities to choose when they have capital to invest. No one has the time or resources to filter through hundreds of opportunities to find which ones are the most promising. To make it easier, many investors define a set of filters to find deals that meet their return criteria.
Two of the most important return metrics in commercial real estate are the capitalization rate and yield. Many investors use this to determine whether an investment is worth the risk. This makes it important to know the difference between the two.
In real estate investment, the capitalization, or cap, rate is a metric that calculates an asset’s potential rate of return (ROR) using its net operating income (NOI) and its market price. Calculating this will give an investor a few key pieces of information about this potential investment.
Potential Return: The cap rate represents the potential ROR on a property assuming that it was purchased entirely with cash.
Risk: Because it measures the potential return, it can also be used to determine the market’s perceived risk on the commercial real estate asset. A higher value could indicate the market sees more risks and demands higher returns. A lower value means the market sees lower risk, so the returns may be lower.
Cap rates tend to vary by location and property type. For example, an office building in Des Moines likely has a higher numeric percentage than a multifamily commercial asset in Miami.
Asset Value: Based on the data inputs for the capitalization rate calculation, investors may also use it to calculate a property’s potential value. This is especially useful for investors trying to estimate purchase and sales prices in a pro forma.
The cap rate is an important and versatile financial metric, so it benefits investors to understand how to calculate and use it. Savvy investors will use this to determine their investment strategy relating to their portfolio, too.
The formula to calculate cap rate is:
Capitalization Rate = NOI / Property Value
While it might seem straightforward, obtaining the necessary inputs can be tricky. Net operating income is calculated as an asset’s gross annual income subtracting its operating expenses, such as property taxes and maintenance. Property value isn’t always available or known at the time of calculation so investors might use a value estimate, purchase price estimate, or appraised value.
Yield is the amount of an investor’s annual return based on the amount of money paid for the land or building. The primary focus for the yield is estimating the return produced by income, not capital appreciation.
The formula for calculating yield is:
Yield = Annual Income / Total Cost
Yield can be measures on a “levered,” meaning with debt, or “unlevered” (without debt) basis. The formula can be adjusted to reflect which yield is being calculated.
Unlevered Yield = NOI / Total Cost
Levered Yield = Cash Flow After Debt Service / Down Payment
In most cases, the levered yield quotient will be higher than unlevered because less cash is put up front into the deal.
The formula to calculate cap rate is:
Both the cap rate and yield are measures of annual returns. Since cap rate uses property value as the denominator in the formula, as these values rise, the calculated rate falls.
For example, if a certain asset produces $100,000 in NOI and has a value of $1 million, the resulting cap rate is 10%. If that same $100,000 in NOI is applied to an asset valued at $1.2 million, the cap rate falls to 8.3%.
With respect to yield, rising prices and falling cap rates could result in potential lower yields. This indicates the property is more expensive to purchase, making the yield fall.
To demonstrate how the capitalization rate and yield work in real estate investing, consider the example below.
The purchase price of a property is $5 million, with an estimated market value of $5,250,000. The projected NOI is $400,000 with cash flow after debt $200,000. To buy the property, the investor must put a down payment of $1 million dollars.
Using this information, an investor can calculate the following metrics.
Investors would benefit from noticing that there is a large difference between the purchase price and the market value. This does not mean it is the norm; it was mostly for the example. It helps to illustrate the difference between cap rate and yield. In this fictional scenario, the cap rate is 7.61% and the unlevered yield is 8.0%, but when debt is added, the yield rises to 20%.
Cap rates are somewhat subjective, meaning there is no “good” cap rate. They are highly dependent on the market, asset type, rental income stability, the pace of growth, leasing activity, and condition of the property. Most commercial properties trade at a general cap rate range of 4-10%, but there are exceptions.
Yield is a bit more objective, but still measured relative to a commercial real estate investor’s return requirements. Generally, a yield in the 8-15% range is considered great, especially in today’s economy where it can be difficult to achieve a 6-7% yield, but if an investor requires a 20% return, then this range would fall short of their expectations.
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