Capitalization Rate and Value-Add Real Estate

The Usual Explanation

I’m sure you’ve read this definition of cap rates:

Cap rate is the return you would get if you paid cash for the property. For example, if you paid $1,000,000 for a property, and it produces a NOI (net operating income) of $100k/yr, that's a 10% cap rate. 

Cap Rate = NOI/Purchase Price

Lately, I’ve seen a lot of articles discussing cap rates that use some form of that definition. I suppose this is because cap rates are seen as a scary, complicated subject. But they do not have to be! In fact, the average real estate investor must understand what cap rates are, and what they are for, in order to be profitable.

What Is Missed

The above definition really misses what a cap rate is. It tells you how to calculate it, but it doesn’t tell you what it’s for or how to use it. As a result, many misinformed investors try to buy properties of all types and conditions by comparing cap rates. This means investors are potentially passing on solid deals. “Run the numbers” is a popular phrase in the real estate investor world, but if an investor is ever going to make money on their investments, not only must they know how to “run the numbers”, but they must know what those numbers mean and when to use each number.

So, What Is Cap Rate?

To understand what a cap rate is, let’s look at the word itself. Cap is short for capitalization. From dictionary.com:

5. to supply with capital.

So, a capitalization rate is the rate at which a property supplies capital to the investor. Importantly, they tell us the rate at which capital is supplied by the property at the given price. This is where the “how” comes into play.

A property priced at $1,000,000 whose NOI is $100k/yr has a cap rate of 10%.

In the above example, if the property were priced at $500k, but still produced $100k in NOI, the cap rate would then be 20%.

What’s It For?

Cap rates can be used for:

1. Determining how quickly an investment recoups its initial outlay. In the above examples, a $1M property producing $100k/yr NOI for a 10% cap rate means the investor will recoup their $1M in 10 years. A 20% cap rate means the investment is recouped in 5 years.

2. Comparing stabilized properties against one another. Because the debt piece of the capital stack is not accounted for, two similar properties can be compared via the cap rate. Debt in the capital stack introduces variability between multiple properties - every property’s debt is different. A cap rate ignores that variability in order to provide a fair comparison between competing properties.

The 2nd point is the most important for this post. Cap rates are only good for comparing stabilized properties. Stabilized means the property is 90+% occupied and does not need major capex (capital expenditure) to get the NOI to where it should be. But what if the property needs a heavy lift with a lot of capex? For that property, the cap rate will not be helpful.

Yield On Cost: A Better Metric

Yield on cost is a measurement for determining the total yield a value-add project will produce given the total project cost. YOC takes into account the equity, debt, and capex. Here’s the formula:

Yield on Cost = NOI at Stabilization/Total Project Cost

What makes YOC a better metric for value-add? When used in conjunction with cap rates, it tells an investor the premium they are receiving for taking on the additional risk of buying a value-add property over a stabilized property.

As an example, say the stabilized properties in an area have a cap rate of 5%. An investor is looking at a property in need of heavy capex. He calculates YOC to be 6%. At that point, the investor must decide if the 1% premium they will receive in yields from the value-add property is worth the risk. If not, they buy the stabilized property.

Consider the following scenario...

A market has a going cap rate of 5%.

Property A (Value-Add): $800k purchase price, 200k capex needed. NOI at purchase is $40k/yr. After stabilization, NOI is $80k/yr. The YOC is 8% and the value of the building is now $1,600,000.

Property B (Stabilized): $1,000,000 purchase price, no capex needed. NOI at purchase is $50k/yr. Since it's already stabilized, NOI won't change - it's still $50k/yr. Building is still worth $1,000,000.

If an investor had looked only at cap rates when purchasing, they might have chosen property B; both are 5% cap buildings and the NOI of property B is higher in absolute terms. However, looking at a YOC of 8%, property A might make the additional risk of capex worth the investment. There's more profit to be had by taking the risk on property A.

This example ignores "natural inflation" for simplicity.

The difference between the market cap rate and the YOC is called the development spread or investment spread. Obviously, an investor wants the spread to be as large as possible - the larger the spread, the more profit to be made at disposition.

Conclusion

My main motivation for writing this post was to give clarity on what cap rates are for and what they are not for. I also wanted to put yield on cost at the forefront of the conversation - this metric doesn’t get a lot of blog posts! Yield on cost allows the investor to see their potential returns weighted against the risk, otherwise known as a risk-adjusted return. If you have any questions or suggestions, please comment below!