Investing in Santa Barbara Real Estate - What is a Cap Rate Really Telling You?

Capitalization rates, or cap rates for short, are generally defined as the upcoming year’s scheduled income divided by the price of the property. However, if we look into the derivation of the cap rate, we learn quite a bit more about this misunderstood metric.

A quick breakdown of the Gordon Constant Growth Model for dividends can reveal some interesting concepts that can be related to a cap rate. The Constant Growth Model is a variant of the discounted cash flow model and without going into the derivation here, the end result states that the current price of a stock should be equal to next year’s dividend divided by the discount rate minus the growth rate.

Price of stock = D / (k-g)

Where:
D = next year’s dividend
k = required rate of return on the investment
g = constant growth of Income for the investment

Similarly, investment real estate is often valued by using a capitalization rate (often called cap rate for short). The income capitalization method of valuation equates the value of a real estate investment to next year’s income divided by the cap rate.

Value of real estate = Next Year’s Income / Cap Rate

Very few investors realize the true implications of these two formulas. Investors often view the cap rate as a price predictor and compare largely disparate properties using cap rates. For instance, you may hear the phrase “retail cap rates are around 9.5%,” yet your strip mall just sold for an 8% cap rate and one across the street sold for a 12% cap rate. The real estate market, while rather inefficient, isn’t really THAT inefficient.

So how can there be such a variance in return demand?

The difference is all in the denominator, we can equate the cap rate to the (k-g) part. If we think of a cap rate as the discount rate minus the growth rate, we can understand that the discount rate (return demand) isn’t really changing as much as the cap rate would imply.

What is actually changing is the expected growth rate.

The variance is almost always caused by the market’s perception of future growth. The difference between the two sales above is that the one which sold at an 8% cap rate likely had below-market rents or escalators in the leases while the one which sold at 12% had above-market rents or leases expiring soon, predicting a future drop in income.

Clearly, the only way to properly value the real estate is to take these fluctuations into account by using a discounted cash flow model and a software package such as ARGUS to handle the leasing assumptions.

However, no matter how hard we try, we still can’t get completely away from the cap rate. We can use the discounted cash flow model for a period of time (usually 5-10 years) but in reality, our ability to predict the future is rather limited, especially outside these time periods. (Ideally, we prefer to use a Monte Carlo simulation to handle this scenario, but on smaller deals where this method is too involved, we still use the DCF) At any rate, at the end of these periods, we need to have either a disposition price or some way to handle the cash flows in perpetuity. The cap rate returns, this time as the Constant Growth Model, also sometimes called a reversion rate in real estate investment modeling. After the cash flows have been discounted back to present day for the analysis period, we use the cap rate to find a value at the end of the period and then discount that rate back to the present.

In a 5-year analysis, you end up with the following:

Value(0) = PV(CF1) + PV(CF2) + PV(CF3) + PV(CF4) + PV(CF5) + PV(CF_ConstantGrowth)

And, in this scenario, we must use the precursor to the cap rate, the Constant Growth Model, to calculate the final figure.

As we’ve shown, the cap rate is used as a simplistic calculation, but understanding the mechanics behind its use allow sophisticated investors to properly apply the metric.

Source: CREMODELS, “What is a CAP Rate telling you?” http://cremodels.com. Accessed September 2, 2014. http://cremodels.com/2011/06/05/what-is-a-cap-rate-really-telling-you/