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Tuesday, September 18, 2012

The Story Behind Cap Rates

By Rand Stephens (Houston)

Short for capitalization rate, a "cap rate" is the unlevered annual cash-on-cash yield of a real estate investment.  Divide an investment property’s annual net operating income (“NOI”) by the asset value, and you have the annual yield assuming an all-cash investment.

The difference between cap rates and the 10-year Treasury (“Spread”) is supposed to represent the risk premium of owning real estate versus the 10-year Treasury, which has traditionally been thought to be the least risky comparable investment since it’s backed by the credit of the U.S. government.

Cap Rates vary based on asset class (office, industrial, retail, multi-family, etc.), and the Spread, when looked at over time, provides investors a perspective on current valuations compared to other time periods.  This analysis is similar to how investors look at historical price/earnings multiples for stocks to get a feel for whether the overall market is underpriced or overpriced.

Since most investors use debt to acquire investment property, they are underwriting the investment on a levered basis using an internal rate of return investment analysis.  With debt involved in the equation, a real estate investment takes on considerably more risk than owning a property with no debt, and using a cap rate when a property is levered as a barometer for reflecting a risk-adjusted return compared to the 10-year Treasury, is not particularly relevant.

In addition, investors use cap rates in their underwriting analysis like a comparable, to check a sales price or valuation of a property, compared to other simlar transactions.  Cap rates are also used in an investment analysis as a way to calculate a terminal value at the end of the projected investment period.

Spreads have been increasing, which means as the Spread moves back into a more historical norm, otherwise referred to as "cap rate compression", property values will go up the  same way bond values go up when interest rates come down.   

With Spreads at historical highs, investment real estate looks like a very attractive asset class.

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