Commercial real estate investors love to talk about cap rates, and for good reason: the underlying data is fairly accessible and the math is relatively simple.
In the most basic of terms, an investor calculates the net operating income (NOI, or net income) based on removing all applicable operating expenses from the gross income. Dividing the net income by the prevailing cap rate for similar properties will give a crude – albeit useful – indication of the value. For investment real estate, it’s the proverbial “back of the envelope” analysis.
Let’s give a quick example:
A property has gross annual income of $150,000. The property taxes, building insurance, management fees, common area maintenance and respective utilities account for $50,000. Deducting these expenses from the gross income yields $100,000 in net income. If the investor is satisfied that similar properties have sold, or are currently available for sale, reflecting a 8% cap rate, an estimate of value would be $100,000/0.08 = $1,250,000.
All formulas are fraught with limitations, and the cap rate calculation is no different. From a real estate perspective, the most noticeable limitations are the failure to account for any changes in income or any benefits of financial leverage. The cap rate method, also known as the income approach, will not account for any increase (or decreases) in rent, nor will it account for any changes in the anticipated selling price. By nature of the calculation, it implicitly assumes that the cash flow (in the form of Net Income) will continue without change in perpetuity.
To account for these shortcomings, many sophisticated buyers progress from the cap rate method to discounted cash flow (DCF) analysis, which provides a more advanced measure of calculating the value of the property or development. DCF analysis is based on the time value of money, described as simply as possible as follows: a dollar in the future is worth less than a dollar today. Think of discounting as the opposite of compounding. If you have $100 and earn 10% each year, after the first year you’ll have $110. In year 2, you’ll have $121. The extra $1.00 in this example if from earning interest on interest. Just as it’s possible to calculate many periods in the future, you can also do the opposite and discount a future amount to present value. $121 that can be expected in two years, discounted at 10% is worth $100 today. Discounting to present value isn’t just a real estate investment technique, it’s one of the cornerstones of finance in general.
Back to the real estate example, an investor would discount the future cash flows (including anticipated increases / decreases in net income and the sale price) back to a present value. Typically this would also take into account any leverage and may even include taxes. The ultimate outcome of this type of analysis is to calculate the Net Present Value (the sum of all discounted cash flows) and the Internal Rate of Return (the overall rate of return taking into account all cash flows). Both metrics provide much more insight into the viability of an investment than that of a simple cap rate calculation.
This is admittedly an overly simplified explanation of a complex topic. In fact, entire courses and programs are devoted to this principle and there is very sophisticated and expensive software that can be used to build the investment model.
Our intent it not to confuse or overwhelm an investor, but simply to illustrate there is a lot more analysis that can happen beyond simply using cap rates.
Here are a few resources if you’re interested in learning more about investment real estate analysis:
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