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.
Question: Can you convert a cap rate into an investment return?
Answer: If investors happen to know an appropriate cap rate for an asset, they can convert that into an investment return by adding the cash flow growth rate to the cap rate. The cash flow growth rate may equal the rental growth rate as long as the rental income and operating expenses grow at the same rate. Once an investor has determined the expected investment return, known as the discount rate, it can be used to perform discounted cash flow analysis in Excel. This allows an investor to determine the value of a property by computing the present value of its future stream of cash flows.
Question: Can you convert 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, and it should equal what an investor could achieve with other investments that have a similar level of risk. The total expected return is sometimes referred to as the opportunity cost of capital (OCC). An investor can convert an expected return into a cap rate by subtracting the cash flow growth rate from the OCC.
Question: What methods are used to compute either 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:
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
Apartment Property Valuation uses this approach to calculate total return expectations and uses the following formula to determine cap rates:
Cap Rate = (Risk Free Rate + Capital Expenditures) - Expected NOI Growth + Real Estate Risk Premium
The website tool gives users flexibility to establish the level of required capital expenditures.
The calculation 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.
- 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.
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.
This involves using surveys to ask real estate investors what their return expectations are for specific types of real estate investments.
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.