Posted by SMARTCAP
What is a cap rate, what does cap rate compression mean and how do both affect commercial real estate valuations? In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula below: Capital Cost (asset price) = Net Operating Income/ Capitalization Rate For example, in valuing the projected sale price of an apartment building that produces a net operating income of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857 ($10,000 / .07 = $142,874).What is a cap rate?
This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal. Capitalization rates are often used to reflect the risk of an individual investment from a market stand point. The lower the cap rate, the lower the perceived risk of a particular investment is and thus the higher the cost of the asset.
As an example, Multi-Family investments on Capitol Hill in Seattle in 2015 are trading as low as a 4% CAP Rate, while a grocery anchored retail location might be trading at a 6% CAP Rate. If each of these two properties had a Net Operating Income of $500,000 the Multi-Family Unit would have a much higher Market Valuation:
- Multi-Family Valuation: $500,000 / .04 = $12,500,000
- Retail Valuation: $500,000 / .06 = $8,333,333
In this case, the market consider Multi-Family on Capitol Hill to have a much lower risk factor and thus a lower cap rate and higher price.
What is cap rate compression?
In 2010, the average cap rate across all single and multi-tenant retail investment sales in Washington was 7.5%.
In the first quarter of 2015, the average cap rate for retail investment properties in Washington is over 120 basis points lower than in 2010. The average cap rate for the 32 retail investment sales in the first quarter of this year was 6.29%.
So, what could this mean to the typical investor?
A $5,000,000 asset that was valued at a 7.5% cap in 2010 would now be valued at $5,961,844 using today’s average cap rate. Of course, there are many other factors that play into cap rate, but that is a 19.23% increase over the last five years. In this scenario, we are not including any rent growth or debt service pay down that may have occurred which would also increase the return on equity. This is simply showing that as a market gets stronger and the perceived risk of an investment goes down, the market cap rates will compress and thus increase the value of a property.
TAGS: Real Estate Education
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Now, let's delve into the concepts presented in the article:
1. Cap Rate (Capitalization Rate):
The capitalization rate is a fundamental metric in real estate investment. It represents the rate of return on an investment property based on its expected income. The formula, as mentioned in the article, is:
[ \text{Capital Cost (Asset Price)} = \frac{\text{Net Operating Income}}{\text{Capitalization Rate}} ]
In simpler terms, it's the ratio of the property's net operating income to its current market value or acquisition cost. A lower cap rate indicates a lower perceived risk and a higher valuation.
2. Direct Capitalization:
Direct capitalization, as described in the article, is a common method for valuing income-generating properties. It involves applying the projected capitalization rate to the property's net operating income to determine its market value.
3. Market Standpoint and Risk Perception:
The article emphasizes that cap rates are often used to reflect the risk associated with an investment from a market standpoint. A lower cap rate suggests lower perceived risk, leading to a higher asset value.
4. Examples of Cap Rates:
The article provides examples of cap rates for different types of properties. For instance, it mentions Multi-Family investments on Capitol Hill with a 4% cap rate and a grocery-anchored retail location with a 6% cap rate. The lower cap rate for Multi-Family indicates a higher market valuation due to a perceived lower risk.
5. Cap Rate Compression:
Cap rate compression refers to the phenomenon where cap rates decrease over time, signaling a decrease in perceived investment risk. The article highlights a specific instance of cap rate compression in Washington from 2010 to 2015. A lower average cap rate in 2015 (6.29%) compared to 2010 (7.5%) indicates a stronger market and reduced perceived risk.
6. Impact on Property Value:
The article illustrates the impact of cap rate compression on property values. Using a hypothetical $5,000,000 asset valued at a 7.5% cap rate in 2010, the current average cap rate of 6.29% would increase its value to $5,961,844. This signifies a 19.23% increase in value over the five-year period, solely due to cap rate compression.
In summary, the concepts of cap rates, direct capitalization, market standpoint, cap rate compression, and their impact on property valuation are essential elements in understanding the dynamics of commercial real estate investment.
