Question: Does the cap rate reveal the return on investment?

Answer: No. The term "cap rate" gets used a whole lot in the real estate business and probably gets more play than it really deserves. What most people really want to know is what return a real estate investment will generate. That way, they can compare real estate investment returns to expected returns from other asset classes such as stocks, bonds or commodities.

The cap rate tells us only about the amount of expected net income in the first year of ownership. It is the ratio of year one income over the purchase price. By contrast, a return on investment calculation would take into consideration the net income generated each year throughout the entire holding period as well as the amount of proceeds at sale. The return could vary greatly depending upon the level and cost of any debt financing used to acquire the property.

The best way to calculate the expected return on investment is to make a projection of the expected cash flows during each year of the holding period and then perform Discounted Cash Flow Analysis. Investors can use the Internal Rate of Return (IRR) function in a financial calculator or spreadsheet to run the computation.

Real estate cap rate for apartments

Question: Can you convert a cap rate into an investment return?

Answer: If investors know the cap rate for an asset, they can convert it into an expected investment return by adding the expected cash flow growth rate to the cap rate. The result shows the investment return assuming no debt financing is used to buy the property. Note that the cash flow growth rate will equal the rental growth rate only if rental income and operating expenses grow at the same rate.

If an investor plans to use debt in the capital structure, knowing the unleveraged expected return can come in handy, since it can be used to perform discounted cash flow analysis. This would allow the investor to project leveraged investment returns using various levels of financing or determine the Net Present Value of the cash flows.

Question: Can you convert total return expectations into a cap rate?

Answer: Yes. If an investor can project the expected unleveraged return for a particular real estate investment, then it is possible to convert that return into a cap rate. The expected return should stem from both annual operating cash flow and appreciation. An investor can convert an expected return into a cap rate by subtracting the cash flow growth rate from the total return.

Question: What methods are used to compute either total expected returns or cap rates for real estate?

Answer: There is no single best method to calculate either cap rates or total expected returns for real estate. The primary approaches are as follows:

  1. Risk Premium or Build-Up Approach:

    This approach reveals what discount rates should be using historical risk premiums to represent current return expectations. Investors can use the formula below to calculate an appropriate discount rate for an investment:

    Discount Rate = Risk Free Rate + Real Estate Risk Premium

    Risk premiums can be used to compute cap rates using this formula:

    Cap Rate = (Risk Free Rate + Capital Expenditures) - Expected NOI Growth + Real Estate Risk Premium

    Note that the valuation tool on Apartment Property Valuation gives users the flexibility to establish the level of required capital expenditures.

    The Building-Up Method starts with the 10-year treasury yield and adds expected premiums for the following factors that add risk to the investment.

    • Risk Free Rate. This is equal to the 10-year yield on US Treasury bonds.
      PLUS:
    • Historical Institutional Property Risk Premium. This is the average premium over the risk-free rate since 1984 for institutional quality apartment properties. The data is derived from NCREIF Property Index Returns. Click here to view year-by-year returns.
    • Property Size Risk Premium. This provides an adjustment for non-institutional quality properties, which we define as apartment properties valued at under $25 million.
    • Construction Quality Risk Premium. The premium is based upon property age, ceiling heights and number of stories.
    • Market-Liquidity Risk Premium. The premium is derived from the APV Location Tier determined by the APV United States Apartment Location Ranking System. Click here to calculate the APV Location Tier for a given property.
  2. Market Extraction Approach:

    This entails estimating expected returns by observing cap rates at comparable properties. Local real estate appraisers, real estate brokers or service providers are usually the best source for finding observed cap rates at comparable properties. If using an observed cap rate to figure out expected returns, the growth rate should represent the long-term rate of growth in cash flow.

  3. Survey Approach:

    This involves using surveys to ask real estate investors what their return expectations are for specific types of real estate investments.

Real estate cap rate for apartments

Question: What should you do if you do not know the appropriate cap rate or the expected return for a particular piece of real estate?

Answer: Use the approaches above to figure it out. Alternatively, you can enter the property address, physical characteristics and income and expense projections into the cap rate calculator at apartmentpropertyvaluation.com. The tool provides cap rates for properties throughout the United States.

Comparing Approaches for Finding Expected Returns for Real Estate:

 

Market Extraction vs. Build-Up Method

One common approach for finding cap rates is to use Market Extraction, which involves looking at cap rates of recently sold, comparable properties and then using those cap rates as a guide in evaluating the subject property. Another approach is The Build-Up Method, which produces a total return expectation by adding risk premiums to the risk-free rate of return, or the return generated from investing in US treasury notes.

In theory, the two approaches should produce similar discount rates, or total returns. If not, it is an indication that properties are being mispriced in the marketplace compared to historical pricing levels.

The build-up method is helpful for spotting inflated asset prices, since it leads to valuations based upon historical returns. If investors rely exclusively on the market-extraction method, they run the risk of participating in and contributing to price bubbles in real estate.

A buyer of real estate may be more interested in what a cap rate should be, while a seller tends to be particularly interested in how market participants are pricing assets at a particular moment in time. It is up to the investor to reconcile the discount rates stemming from the various approaches. The exercise of valuing properties using several approaches can help to determine whether it is a good time to buy or sell real estate.

In some cases, it is difficult to extract capitalization rates from the market, because there are few sales comparables. This is particularly true in many smaller apartment markets where the build-up approach is a better option than market extraction.

Determining cap rate for real estate

Current Cap Rates


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