There are many financial metrics that underwriters use to evaluate the viability of a real estate investment during screening. One such metric is the capitalization rate, often referred to as a “cap rate.”
With the current disruption in the financial markets caused by COVID-19, it is anticipated that cap rates will be impacted. To understand how the current economic climate may affect cap rates and what this ultimately means for investors, we will first explain what a cap rate is and how it is utilized when underwriting real estate transactions.
What is a Cap Rate?
Simply put, a cap rate is the ratio of a property’s net operating income (NOI) to its market value, and provides a quick approach to determine a property’s annual return in the first year of an all-cash (unleveraged) purchase. The property’s total revenue less its total expenses, exclusive of debt service, equals its NOI, which we’ve previously explained in further detail.
While there are varying methods to calculate a property’s cap rate, a simple approach is to divide a property’s NOI by its recent sales price, as shown in the formula below.
NOI/Value = Cap Rate
Here’s a real-world scenario to help further explain a cap rate:
Assume an investor purchased an apartment building for $1 million without utilizing any debt. If after expenses, the property generates $60,000 in NOI, then the cap rate would be 6%.
$60,000 (NOI)/$1,000,000 (Value) = 6% (Cap Rate)
This means that the investor would earn a 6% annual return on its initial $1 million unleveraged investment.
Conversely, by researching cap rates from recent sales of comparable properties in a given market and adjusting those to account for differences in the subject property, the investor can estimate a cap rate for that property. The investor can then determine a property’s value by applying the cap rate to its stabilized NOI, as shown in the formula below.
NOI/Cap Rate = Value
For example, if the investor wanted to estimate what the market value is for a prospective property that generated $75,000 in NOI, and through a survey of recent sales of comparable properties, they estimated a cap rate of 6%, they could estimate the property’s market value as follows:
$75,000 (NOI)/6% (Cap Rate) = $1,250,000 (Value)
In order for this method to be useful, the property must be stabilized, which means it has completed the lease-up of newly delivered units in the case of a new development or otherwise achieved normal occupancy and rent levels. In addition, it’s important that cap rates are derived from similar properties to the one being evaluated. The cap rate on a retail shopping center should not be used to determine the value of a multifamily property.
Examining Risk with Cap Rates
Because cap rates indicate a property’s potential rate of return for buyers, it can be used to evaluate investment risk between multiple investment options.
Let’s return to our investor from the example above who had $1 million to invest. As an alternative to purchasing the multifamily property, the investor could have invested in U.S. treasury bonds, which are regarded as very safe investments as they are backed by the full faith and credit of the U.S. government. Additionally, treasuries provide fixed-income payments and returns the investor’s principal at maturity. Due to their perceived safety, treasuries typically pay low yields relative to other investment vehicles. For this example, let’s imagine a treasury paid a 1% yield for this relatively risk-free investment.
In choosing how to invest the $1 million, the investor could compare the cap rate of the multifamily property investment with the treasury yield. The 5% difference between the 6% cap rate of the multifamily property and the 1% treasury yield, is known as the risk premium. The 5% premium is the reward an investor could potentially earn for taking on the risk of investing in that multifamily property.
What Can Impact Cap Rates?
There are many factors that could affect the cap rate of a property. This includes the characteristics of the property, including its size, age, or location, but also market economics such as supply and demand.
For instance, in an area where the demand for rental housing is high, it would reduce the risk to lease up that property. Due to this demand, there could be many active investors seeking to buy properties, which adds liquidity to the market. This kind of market will naturally have less risk associated with investing in multifamily properties, and therefore, the market’s cap rate would be compressed relative to other, less active markets that have less liquidity.
By monitoring cap rates, one can track the trends of a market. If an area has expanding cap rates, that could mean demand is waning and there is potentially more perceived risk in that market – hence a higher return is expected to take on that risk. If cap rates are compressing, that could indicate that properties are in high demand and the market is strengthening – hence a lower return is expected to take on less perceived risk.
How Else are Cap Rates Used?
Cap rates are used when evaluating the price to buy or sell a property. Buyers would prefer to acquire a property at a higher cap rate, which indicates a lower initial investment, while sellers want to sell their properties at lower cap rates, indicating a higher exit value. Cap rates can also be used to project an exit price for an investment to determine what the returns would be to investors.
For example, by estimating what NOI will be three years into an investment, and formulating what a reasonable cap rate assumption will be at that time, one can project the sale proceeds that could potentially be earned from a sale and what can be distributed to investors. Of course, it is imperative that a sensitivity analysis be performed to account for several different NOI and cap rate scenarios during year three of the investment’s hold period. This is an important component of the underwriting process.
How COVID-19 Could Affect Cap Rates
As a result of the COVID-19 outbreak, financial markets suffered and many people lost their jobs, adding more uncertainty to the outlook of the U.S. economy. Liquidity became a major issue for businesses and individuals. The U.S. 10-year treasury yields began the year at 1.88%, but are currently hovering around .6%, as of the writing of this article.
Our investor with the $1 million to invest would now require a larger premium – approximately 5.4% at current treasury yields – for the risk of investing in the multifamily property. That spread could increase even more, due to the heightened uncertainty added to the market because of the virus. Many anticipate that cap rates will increase, which would result in property values decreasing. If this occurs in markets that have historically rebounded after downturns, or in markets that have developed strong economic fundamentals (such as high employment rates with good paying jobs) since the Great Recession, there could be historic buying opportunities.
Despite the financial crisis caused by COVID-19, ArborCrowd is actively screening new opportunities. As we continue to vet deals in various markets during this time of uncertainty, the cap rate is one tool we utilize to assess risk and returns. By utilizing a market cap rate, along with other financial metrics, we can identify and root out deals that have unrealistic projections. It could also allow us to find deals at a significant discount to capitalize on before the economy rebounds and begins a new market cycle.