Green Street Advisors



Many Ways to Quote a Cap Rate

One of the metrics most widely used by real estate investors is the capitalization rate, or cap rate. The cap rate is a useful tool to compare market pricing across transactions, markets, sectors, and even publicly traded REITS, and it can serve as a base for real estate investment decisions. Unfortunately, the world of commercial real estate has not adopted a standardized definition for cap rates that market participants could universally adopt. As such, it’s important to understand that a variety of definitions exist, and also what each one means.

What is a cap rate?

In the simplest sense, a cap rate is the yield generated by a property or group of properties. Mathematically, it’s the net operating income (rents minus expenses), or “NOI,” expressed as a percentage of a property’s value. For example, a property that recently changed hands for $100 million and is expected to produce income of $5 million has a cap rate of 5%. Investors who know or can estimate any two of the variables - NOI, asset value, or cap rate – can calculate the third. Cap rates have an inverse relationship to asset value, so when asset values rise, cap rates fall, and vice-versa. Many investors focused outside of real estate often use the inverse of the cap rate to look at the same information; cap rates are essentially an inverse earnings multiple, therefore a cap rate of 5% is analogous to a 20x earnings multiple. Yield and cap rate are two sides of the same valuation coin.

Definitional problems

Like earnings multiples, not all cap rates are created equal. It is common for investors to see multiple cap rates quoted for a single transaction. The difference usually stems from the calculation of net operating income. For example, the income could be calculated on a pro- forma basis (i.e., estimated next 12 months), or it could be calculated based on the most recent trailing three-months of income, annualized. In periods of rapidly increasing or decreasing income, these two numbers can be materially different. Cap rates using either approach are both technically correct, they are just calculated differently. Net operating income can also be calculated including or excluding capital expenditures (or cap-ex for short). Capital expenditures are the costs associated with the long-term ownership of commercial real estate that are capitalized, not expensed. Three of the more common cap rate definitions that use different cap-ex reserve assumptions are nominal, market, and economic cap rates.  And, each of those cap rates can be quoted based on pro- forma or trailing income. Green Street quotes all three on a pro-forma income basis.

cap-rate-calcs* Different property sectors have different “standard” cap-ex deductions. All of these standard deductions are far lower than what an owner actually spends, and they are simply helpful to normalize quoted cap rates.

A powerful starting point 

While cap rates alone are not a sufficient basis for making investment decisions, they are a powerful starting point. Fundamentally, cap rates provide investors with signals on the market pricing for investments. But before investors incorporate cap rate data into their investment decision-making process, they must first know how the cap rates were calculated, and must then standardize that data among all of the other transaction, market, sector, and company cap rate data they may be working with. Green Street maintains hundreds of unique cap rate series, encompassing the current and historic values for all major property sectors, all major U.S. metros, and for the majority of publicly traded REIT portfolios. All of those cap rates are standardized to ease comparison. At Green Street, an accurate cap rate calculation is a fundamental component of an analyst’s valuation process. It forms the basis of the Net Asset Value-based pricing methodology and the return expectations that are the foundation of Green Street’s work on company, sector, and market selection.

To learn more about Green Street’s Cap Rate Observer, Green Street’s valuation methodology, or other real estate solutions, contact us.

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