Capitalization rates are a rather simple concept in real estate investing that is often ignored by analysts in other sectors and asset classes. Simply put, the capitalization rate is a kind of yield, currently valued, that helps real estate investors understand if a property is reaching its fullest potential in terms of income generation.
Let’s break it down. The capitalization rate is simply the net operating income divided by the current value of the property (i.e., how much it would sell for if sold today). Since current valuation is in a sense theoretical, the cap rate is theoretical too, but there are ranges within which analysts must work. A 1br condo in a mid-sized American city can’t be valued at a billion dollars just to influence the cap rate, for instance.
To see this in action, let’s assume that an office building of 10,000 square feet is currently worth $10 million, and it sells property for $1 per square foot. The cap rate, then, would be 1.2% ((10000*12)/$10,000,000). Obviously, rents would need to go up on this property, or it’s far overvalued at $10 million!
And this is why cap rates are useful. On the one hand, they provide a way to see if rents are appropriate for the value of the property. On the other hand, they help analysts see if a property or the market itself is overvalued. Since cap rates should tend to harmonize in an efficient market (i.e., in a city all cap rates will be tightly range bound, with variations afforded for age of property, location, etc.), large outliers from this metric are opportunities for investors to either buy or sell, depending on how the cap rate looks.
There’s another useful function for cap rates: REITs. Real estate investment trusts are a kind of income-producing asset that operates like equity in a company—except, in this case, the company’s sole business is buying and renting out property. With such a REIT, a portfolio-level cap rate can be produced by looking at all properties from this formula. REITs with sudden variations in cap rates can also have sudden variations in their stock prices, which is why analyzing and understanding cap rates can help analysts identify mispriced REITs.
Financial analysis of real estate is not terribly popular or exciting for many new investment bankers, but the fact of the matter is that real estate has outperformed just about every other asset class and sector for a very long time—even taking into account the massive crash of 2007-2009. Understanding how real estate is valued can also help analysts get a toehold into this very lucrative alpha-generating sector.