Thursday, August 28, 2008

What is a CAP rate?

by Tim O'Brien, HFO Investment Real Estate, as published in Units Magazine, a publication of the National Apartment Association.

What is a CAP rate?

A cap rate is simply the net operating income (NOI) of the property (before any debt service) divided by the price and it equates to a percentage rate of return if the investor were to purchase a property with no debt (all cash).

Example: NOI = $100,000, Price $1,200,000 CAP rate = $100,000/$1,200,000. Result: Cap Rate = 8.3%.

Supply and demand and the cost of debt are two factors that affect cap rates in a market place. The cap rate is one of the primary determinates of pricing for investment property and there is a direct correlation between market cap rates and current available interest rates for debt on investment property. When interest rates are lower than cap rates, we end up in what we call a positive leverage market; the more one borrows the higher the return on investment.

When interest rates are greater than cap rates, the market is in a negative leverage scenario -- the more one borrows against a property the lower the rate of return is on the investment.

It is also important to understand that the primary advantage of real estate over other investment types are leverage and tax advantages. Most real estate investors want leverage as much as possible because most advantages in owning real estate come with leverage. Like any other investment type, real estate is driven by supply and demand. Investors in real estate normally have a certain threshold of investment return they are willing to accept, depending on the asset and the current market.

As interest rates decline and the cost to borrow decreases investors are willing to accept a lower rate of return on their cash because other investment vehicles offer lower returns.

As interest rates decline, two market forces working to drive an increase in real estate prices: (1) Cap rates are decreasing with interest rates; and (2) Investors are willing to accept a lower rate of return on their money.

Conversely, in a rising interest-rate environment, the opposite is true. When more options exist for investors to achieve a greater rate of return and the cost of debt increases, cap rates increase and reduce the price an investor is willing to pay for an asset.

In conjunction with these effects, the market also plays an important role in cap and interest rates. The higher market demand is in a particular market, the lower cap rates tend to be.

Lower cap rates have a positive affect on prices. Alternatively in a weaker market with lower demand, cap rates rise and values decrease.