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Making Sense of Cap Rates

Simply put, the cap rate is a snapshot of an asset’s unlevered return—its return without accounting for debt or financing. It’s calculated by dividing an asset's net operating income (NOI) by its current market value. The cap rate helps us understand how long it will take for us to recoup our investment in an asset. 

To better understand how cap rates are used by investors to evaluate assets, let’s run through a hypothetical example.

  • Let’s assume that LEX is evaluating a fully-leased luxury apartment building in downtown Chicago that has 25 units each earning $4,000 a month in rent, or $1,000,000 in gross income per year. 
  • To arrive at the Net Operating Income (NOI), we would then subtract the property’s annual expenses including management fees, taxes, and insurance, which total $250,000. The result is a NOI of $1,000,000 - $250,000 = $750,000.  
  • If we know that similar apartment buildings in this Chicago neighborhood have recently sold at a 5% cap rate, we could then divide the $750,000 NOI figure by 5%, resulting in an estimated valuation of $15,000,000.

The 5% cap rate, in other words, means that every year we’ll earn 5% of the asset’s market value in net income. This implies that it will take 20 years for us to fully recover our investment, assuming that rents and vacancy rates stay constant.

Cap rates can also help commercial real estate investors understand the risk and return profile of a specific property, or compare properties side by side. A lower cap rate implies a property with a strong leasing profile in a high-growth area. This is why multifamily apartment buildings trade at very low cap rates (often below 4%) in cities with extremely supply-constrained housing markets, like New York—there’s no shortage of tenants, and consistent rent growth is expected. Conversely, a higher cap rate reflects more risk in the form of more vacancies, more difficulty finding tenants, higher maintenance costs, or a weaker overall market. Investors are compensated for this additional risk with the possibility of greater returns.

It’s important to remember that cap rates alone don’t paint a complete picture. Cap rates are most useful in markets where sales occur often, where there is more information available to determine prices relative to comparable properties. Typically, twelve months of NOI are used in the calculation, and a twelve month snapshot may not be indicative of an asset’s long-term performance. The basic cap rate metric doesn’t include expiring leases and scheduled maintenance (which can hurt NOI), or the cost of debt financing. Cap rate is a starting point, and it’s used alongside a series of other key metrics (including IRR) by our Real Estate team.

September 1, 2022

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