By Fred Matera, CIO, Redwood Trust A lack of affordability will lead to near-term weakness,…
By Trevor Hanson
What are Cap Rates?
The capitalization rate, commonly referred to as “cap rate”, is most powerfully—an estimator of an investor’s potential return on their real estate investment. Mathematically, the cap rate is a data point, expressed as a percentage, that divides an investment property’s net operating income (NOI) with the asset’s current market value (or purchase price). The metric theoretically projects the yield, or return on investment, over a one-year horizon—which as a ratio, also indicates a property’s unlevered, intrinsic value.
Traditionally, the term derives from the world of commercial real estate and is most commonly used as a tool to compare relative value of similar investments. As you may expect, real estate investments with different asset types or in different geographical markets reflect different cap rate trends and patterns—think how profiles of value, income, and expenses would differ between an office building in a major metropolitan city vs. a small shopping center in a suburban town. Beyond these somewhat obvious differentiators, other factors such as the property’s age, condition, tenant creditworthiness or solvency, lease structure, market appreciation, and regional macroeconomic fundamentals also play major roles in cap rate variances.
Why Do Cap Rates Matter?
The value of cap rates to investors lies in the notion that cap rates are also an indicator of risk. Theoretically, the difference between an investment property’s cap rate and the current risk-free treasury rate is said to be reflective of the risk premium taken by investing in said property (in comparison to parking your money in zero risk treasury bonds). Putting this all together, investors arrive at a helpful risk vs. property characteristic spectrum that suggests riskier investments entail a higher proportion of NOI to value in comparison to safer investments which entail a lower proportion.
A Useful Tool, but NOT the End All
Although cap rates are an extremely useful comparison tool for investors, lenders and other relevant counterparties, its use as a pure indication of value or investment strength has its limitations. Most notably is the formula’s omittance of leverage with respect to indicating return on investment.
Its simple calculation assumes the property is free-and-clear or purchased in all cash (in the case of an acquisition). More technically speaking, NOI does not capture debt-service and escrow payments that would ultimately affect an investor’s bottom line or net cashflows.
Beyond this, there are a myriad of other aspects (time value of money, substantial variations in cash-flows, expected income growth from property improvement or capital expenditures, non-arm’s length transactions and corresponding prices) that are also not wholly represented. Some of these aforementioned items can become increasingly complex very quickly—so for the sake of brevity, we will conclude with the sentiment that cap rates should not necessarily be used as the sole instrument in calculating investment value.
Looking at Cap Rates through the SFR Portfolio Lens
While cap rates still hold usefulness in comparing relative value like in the commercial real estate realm, scattered site residential portfolios by nature, do not quite align with the fundamental principles of the cap rate. Despite this, it is becoming increasingly prevalent where investors in the SFR space are deriving a value for a pool of residential properties using the total NOI from their portfolio alongside a cap rate.
From an investment perspective, this might seem sound—you’d think another investor would value or pay the same price that corresponds to an equivalent return likelihood. In reality, it often creates a misalignment in which the whole does not equal the sum of the parts – meaning the efficiencies created by valuing a portfolio as a single investment are not always reflected in the individual market values of each property.
Think about how credit risk, appraisals, and zoning come into play here. A lender (whether they be asset-based, commercial, portfolio, CMBS, etc.) is often required to complete true residential appraisals on investment properties. What this means is their derivation of value is based largely on sales comparisons versus an income approach (another way of describing a cap-rate driven value).
While the income approach is typical in the realm of commercial real estate valuation, it doesn’t quite paint the full picture for SFR Portfolios. From a pure credit risk perspective, think about events of default or foreclosure where portfolios are required to be split and sold in pieces. Should lenders really be valuing the portfolio as a single investment?
In summary, this blog aims to demystify some of the confusions and mechanics around the capitalization rate and its usage in the greater context of real estate investing. While it does justify itself as a powerful and savvy tool, I would recommend that investors consider other factors and take a more holistic approach in evaluating their SFR portfolios.