The Importance of Cap Rates
The integral question, if you don’t know, is what is a cap rate? Now, mathematically, a capitalization rate (or “cap rate”) is an asset’s unlevered net cash flow divided by its value or purchase price. It can also be thought of as the reciprocal of a property’s price-earnings ratio (or “P/E ratio”). So, if a property is valued at a 5% cap, the value is 20x (i.e. 1/.05) the current net cash flow.
What is the importance of a Cap Rate? It provides a value of the property in terms of the potential capital it can provide, thus the name. But, often people are looking for the rate of return they can get out of a property. Does the cap rate equal my rate of return? NO! It’s just an expression of what someone pays for (or values) a property based on today’s net cash flow. To calculate a return, you need to run an old-fashioned IRR calculation. If you want a shortcut for calculating a return, consider this: If cash flow grows by exactly the same percentage every year, your return will be exactly the cap rate plus the growth rate. So, if you buy a property at a 6% cap rate and the net cash flow grows by exactly 1.5% every year, your return (unlevered) will be exactly 7.5%. And when I say exactly, I mean exactly. If this doesn’t sound right, open an Excel file and see for yourself (don’t forget to model a reversion). This is why investors are typically willing to pay a lower cap rate for assets with a lot of upside.
How much does a 1% change in cap rates affect the value of my property?
It depends on a few things. First, a change in value is a function of the percent change in the cap rate, not in the number of basis points of the change.
Example 1-A: Take two properties with the same value. Property A has a cash flow of $500,000 and is valued at $12,500,000 using a cap rate of 4.0%. Property B has a cash flow of $1,125,000 and is valued at $12,500,000 using a cap rate of 9.0%. Now let’s raise each cap rate by 100 basis points. Property A’s value decreases by 20%, or by $2,500,000 to $10,000,000. Property B’s value decreases by only 10%, or by $1,125,000 to $11,250,000. Although A and B started at the same value, they ended at different values even though they each experienced a 1% increase in cap rate. Why? Because for Property A, the 100 bps represents a 20% change in the valuation rate. For Property B, the 100 bps is only a 10% change.
Some of you astute math whizzes might be thinking: Just a second, Einstein. Your math doesn’t add up. The percent change of the cap rate for Property A is not 20%, it’s 25%. Oh and by the way, the change is positive, not negative. And my response would: Yes, Sir Isaac, your math is correct. But you have to look at property valuations in a slightly different way…
As I mentioned toward the beginning of this piece, changes in cap rates are really changes in P/E ratios. When a cap rate changes from 4% to 5%, the multiple decreases from 25x to 20x (i.e. a change of 20%). When the cap rate changes from 9% to 10%, the multiple decreases from 11.1x to 10x (i.e. a change of 10%). Example 1-B is a modification of Example 1-A that helps illustrate this point.
A percent change in value also depends on whether a cap rate change is positive or negative.
Example 2: Consider Property A again with a cash flow of $500,000, a cap rate of 4.0% and a value of $12,500,000. Let’s increase the cap rate by 100 bps to 5%. As before, the value decreases by $2,500,000 (20.0%) to $10,000,000. Now let’s decrease the cap rate by the same 100 bps to 3%. The value increases by $4,166,667 (33.3%) to $16,666,667. Even though the starting cap rates and cap rate changes were the same, the ending cap rates were different (5.0% vs 3.0%) resulting in different percentage changes in valuation rates and values.
Why even use cap rates, especially since the math can sometimes be confusing?
I can’t provide a definitive answer to this question, but I can offer the following: The world of real estate investment is heavily driven by risk, Ieverage and levered rates of return. Cap rates make it extremely convenient for investors to (i) quantify property risk profiles, (ii) compare unlevered returns to the cost of debt, and (iii) easily compute levered rates of return (another topic I will cover in 2020).
Plan for Success
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The Strategic Plan for every new development may be the recommendations contained in a Marketing Feasibility Study or Market Analysis for single-purpose projects. Or, for large or complex developments, it can be produced as a separate document circulated to the physical design team and marketing team prior to completion of the physical master plan. Regardless of packaging, the Strategic Plan ensures that key parameters important to target consumers guide the physical plan and marketing presentation of successful real estate developments.
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Parker Associates and PTC Computer Solutions have worked on a plentitude of projects through the years where many benefited from our experience gained while working in 33 states and 17 foreign countries and for more than 500 developers and builders since 1982. Want to learn how we can assist your next development? Visit our website at https://parkerassociates.com and/or call David WB Parker at 904-607-8763.
J. Chris Parker is a principal of Parker Associates of Jacksonville, Florida, marketing consultants to the real estate industry as well as the lead associate on the new Barclay’s branch, Barclay’s Real Estate. Though based out of Jacksonville, Florida, Chris & David and the team at Parker Associates have worked in 17 Countries and 33 States through the years as well as 65 out of 67 counties in Florida. Chris can be reached at 904-607-8761 or via email firstname.lastname@example.org.