June 27, 2021

Comparing Cap Rate and Return on Cost Valuation

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By

Walter Novicki

Comparing Cap Rate and Return on Cost Valuation

How to calculate a cap rate?

The capitalization rate or cap rate, for short, is one of the metrics used to determine value of a commercial investment. Although the question of what a cap rate entails comes across as straightforward, the answer to this is not always simple. There are a number of factors involved in determining a cap rate and how it is used.

Before we get into the specifics of calculating a cap rate, let’s first understand what it is. It refers to the valuation of a property that you expect to receive in the first year of ownership. This doesn’t include the money spent on the upgrade of the said property or the amount required to acquire it. In simple words, cap rate can be described as a dividend earned given the property was financed with cash only.

The cap rate is determined by the revenue a property makes subtracted by the operating expenses. Divide the result by the purchase price and you have yourself the cap rate of the property.

A cap rate is time-specific. Sometimes investors look at the trailing cap rate as well as the current one for knowing its historical performance. A trailing cap rate is the NOI of a property for the preceding 12-month ownership divided by the sales price. Keep in mind that this is different from the initial cap rate.

Usually a cap rate is representative of the initial NOI of a property and forecasts the NOI for the rest of the 12 months. There may be changes in the NOI because of an increase or decrease in property revenue and operating expenses. In fact, this fluctuation during the ownership is one reason that cap rate is not an accurate measure to determine a property’s value.

There are a number of factors that affect the cap rates. These include the forecasted growth of the property’s NOI, the extent to which liquidity is available to you in the market, the lease length and creditworthiness of tenants. A property’s location also plays a huge role in determining its cap rate. Properties in coastal areas of big cities like New York, London and Tokyo will have global investors flocking to purchase all the assets that exist there. The demand is primarily the reason that prices are high and cap rates are low.

An advantage of investing in real estate located in these areas is that there is an upward growth in its value. The owners can charge a higher rent from the tenants as compared to markets located in other areas.

When should you use a Cap Rate?

Cap rate should be used for properties with the lowest amount of fluctuation in their NOI. In other words, properties with predictable income streams can be best evaluated using cap rate.

When not to use a Cap Rate?

Using cap rate to evaluate properties that require a considerable upgrade and investment is a bad idea. If your property has a lot of tenants moving in and out, the cap rate will be of no use to you because of the fluctuation in the generation of cash flows. To explain it better, let’s take an example of an office building which is only 40% occupied. It may be generating revenue but not enough to cover the operating expenses, resulting in a negative NOI. Of course, an opportunity exists for the owner if he decides to reinvest and stabilize the property to generate a constant steam of income. For such opportunities, we use another measure for evaluation known as the Return on Cost.

What is Return on Cost?

Return on cost is similar to cap rate except it adds the cost needed to stabilize the property and the future NOI to give you a value. You can also call it a forward-looking cap rate as it tells you if your property has the ability to generate more income than a purchase of a stabilized asset. To calculate a Return on Cost, just divide the purchase cost by the expected NOI.

Investors use a number of metrics to evaluate real estate investments including the cap rate and return on cost. If you’re planning to step into this business, it is important that you know how these rates are determined and what are the drawbacks associated with them.

Although cap rate is a good way to evaluate the property, it has limitations as discussed earlier. Discounted cash flow analysis is considered the best way to value real estate as it takes into account the time value of money. For accurate analysis, it is best to use a mix of methods and both trailing and initial rates. Including a return on cost will also help you with precise outcomes.

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