Is Cap Rate a dependent or independent variable?

Question

So my understanding is correct:
The figure represents how productive the property is relative to its value.
The three figures (NOI, value and CR) seem to flow in a circle

Rental demand drives rent price
The expected income stream from that will determine what investors will pay for a property

If these two factors are fairly uniform in a given market, would cap rates vary that much?
I've seen posts here which explain CR as an apples to apples comparison for a market...if the driving forces (demand etc) are consistent, is the CR variability simply how the sellers are pricing the property?

Dion DePaoli · Answer

Cap rate numbers are not 'official' numbers.  They are market driven numbers.  Higher class properties have lower cap rates, in today's market A class in primary markets is around 4% to 6%.  B Class is around 7% or 9% and C class 10% to 12% and D Class around 13% to 18%.  That is just ballpark numbers and will have some variance depending on other criteria like property type or can move based on property location such as prime market or a tertiary market.

The cap rate, like I said, is a market driven number.  As capital flows into A Class properties it drives the price upward which drives the cap rate downward.  Commercial property is related to capital markets.  The markets will respond as the costs of borrowing drop (interest rates go down) you will see a move into CRE or as the returns of less riskier investments such as T Bills goes down you will see a move into CRE.

The market value of the property will be influenced but not based solely on cash flow, NOI or cap rate.  Other things such as additional capital expenditures on the property like deferred maintenance can influence what the property's value is.  A property with a strong cap rate can still be a property that needs a fair amount of recapitalization to maintain its capacity to compete in the local market.  Like owning an apartment complex and having to replace all the roofs or rehab many of the units to make them more modern or repair the common areas of the property such as pool club house areas.

You have to be a little careful when reviewing cap rates from others.  Certainly most experienced commercial real estate agents and investors have a better understanding and properly put the numbers together but I have seen plenty work ups or project summaries which show a cap rate but the NOI they use to figure the cap rate out is flawed or the value they use is flawed.  I guess my point is, while there is a proper way to calculate the number, Cap Rate is sometimes abused and done improperly.

Ned Carey · Answer

Dion DePaoli already gave you a good answer but I will reply specifically to this.

Why do you care?
Does what others pay make a difference to your real estate goals? If cap rates are low that means others are paying high prices and accepting greater risk. Does that mean you should do the same?

In hindsight everyone was paying to much in 2007 and 2008. If you were paying based on what others were paying then, then you were paying to much also.   Good luck - Ned

Ned Carey · Answer

Yes Cap rates will vary. They can vary by property type, residential, retail, office, industrial etc.  They will also vary by property class. A class properties will obviously have lower cap rates and higher prices than D class war zone properties.

Even within a given type and class different investors will evaluate each opportunity differently.

Also exact cap rate is unknowable. What is the cap rate? Is it based on last year actual numbers? Is it what is forecast for the coming year? Are expenses going up? Are they coming down and by how much? Is the cap rate based on the number the current management is achieving or what the new management will achieve?

Bryan Hancock · Answer

The independent variable you should be focused on is your required ROE for a property to work.  You can do a simple WACC computation based on your ROE and loan constant to arrive at a cap rate that YOU care about.  From there if you do all the diligence necessary to find a proper NOI you can simply divide the NOI by YOUR WACC to arrive at a price YOU are willing to pay for the income stream.

What others pay is not really relevant to this analysis.  However, if others in the area are paying less than what your formula says you should adjust your bid price down to be in line with the market.  That is really the only time it should matter.  If your ROE is high enough this shouldn't really be a problem because it will adjust your WACC north and thus your bid price south.

If you arrive at a bid price higher than what the prevailing capitalization rates show the market will pay there is likely some factor you failed to account for properly.  The economic vacancy of the project you're evaluating could be much higher than what you forecast.  Late rent, skips, and other effective vacancy items like "free rent" for a certain time period are indicative of lower class properties where the proper adjustments need to be made to calibrate the NOI properly.  To be overly cautious you should probably consider increasing your required return on your equity on these projects too because the income stream is more volatile than a higher class property would have.  Properly analyzing economic vacancy AND increasing your required ROE will adjust your bid price south.

There really are no independent variables in economics.  Things work as a system and that is why there are econometric models for things like the broader economy.  Using a broad-brushed approach to analysis by using a "market cap rate" is foolish to me.  The only people that may possibly have good information on this are local brokers and they have an agenda that is likely divergent from yours.  Buyer beware!

Derek Carroll · Answer

I agree that cap rates should not be used to evaluate a deal. However if you find that you're purchasing at a cap rate very different from market, time to dig a little deeper.

At the end of the day it all really comes down to NOI and for comparable properties in a similar area market forces will determine the the amount that an investor will pay for certain cash flows (cap rate). Your local commercial appraiser will be a very good source of knowing the cap rates of similar property transactions.

Bill Gulley · Answer

Good point Derek, I do understand that approach and the use in appraisal assumptions, but really, as an appraiser looking at the market, there is no way what I know what an acutal CAP rate is of properties owned by others, they are assumed and compared to what is seen as alternative investments, the problem is that if you drill down, no two RE investments are identical which was my point. We certainly look at them by custom, accept them as a tool to evaluate a deal, but there are better measures, such as the ROI and COC, weighter approaches to an IRR. :)

Derek Carroll · Answer

Cap rates are actually a very important number to be aware of,especially as you consider larger properties. But investment decisions are not based off of cap rates.

Cap rates are important to understand and know because they are the metric most used to value a property. If class a properties are consistently trading at a 7% cap rate in your area and you purchase at a 6.25% then,  all else being equal, you're Payjng too much. Sure maybe there are reasons why you would pay more for a specific property or your cash flow still works but you at least need to understand how and why you are paying more than market.

This is especially important when it comes to financing your properties. Financing options are going to be based on valuations from an appraisal. Commercial appraisals will use multiple approaches to determine value but the most heavily weighted of these approaches is the income approach which uses local market cap rates. If you're hoping for a 75% LTV loan and you're buying at a cap rate lower than market then the property will appraise lower and you won't be getting the 75% loan.

You don't however use cap rates to make your investment decision. Looks at cash on cash return, IRR, ect.

Simply put cap rates are important because they help you understand the local market

Bill Gulley · Answer

I really don't know why RE investors lean on CAP rates, it is a perfrmance ratio for similar investments. RE is not similar, every property is unique. It would make more sence to use it in comparing  portfolios
 rather than a single property.

Where I can look at stocks or bonds and find similar securities, same grade and similar perforamce, liquidity and risk, it is applicable as you can identify opportunity costs. You can not find accurate opportunity costs in real estate, seldom do you really find two choices of properties that are similar in marketability, liquidity, risks and costs to hold the asset. It is also not apporiate to compare a liquid asset to a non-liquid asset, RE is not traded for cash within short periods of time at it's "current" value, for a quick sale the price is discounted to increase demand, much more than a quickly traded asset.

The assumptions Dion pointed out with the classifications or grade of properties is really areflection of the uniqueness between properties. They carry different marketability aspects, the depreciation aspects are different, the costs to carry the assets are different, they are just unique economially.  :)

Ziv Magen · Answer

COMPLETELY concur with Ned Carey, above. Why on earth would you care? If the last decade's taught us anything, it's that you should look at pure cashflow, and nothing else. Why the obsession with cap rates, unless you can predict the future (and so many wiser and more experienced investors than ourselves have tried and failed so many times over...)

Personally, I vowed I'd do my darn best to try and not to fall into the same trap those walking a foot in front of me have just crashed into (as an individual or institutional investor, at least - and would like to hope entire countries would be able to follow the same reasoning process) - I ignore cap rates altogether, to be honest. Net pre-tax, predictable annual income is all I care about, and advise my clients to do the same.

Matt A. · Answer

So it seems to be highly dependent- and subjective.
More of a snapshot for a particular time, and particular investor.

But it can be used as a metric for that place, time, and property type.

Dion DePaoli I was looking for a definition of primary vs tertiary markets etc and it seems to involve both population and market activity. This seemed to be a good explanation on that (and property classes), anything to add to it?
http://www.housingfinance.com/asset-management/defining-the-market.aspx

Is Cap Rate a dependent or independent variable?

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