Starting to contribute to our commercial real estate company blog, does this sound accurate and easy to understand? cap rate vs. internal rate of return...
The cap rate is the percentage of the initial investment that is earned back during year one (year one net operating income). It is the percentage return on one’s investment isolated to the first year of income generated by the investment. (and/or?) The internal rate of return is the return on investment (cash flow for the life of the holding period, or the length of time one owns the investment) in relation to the initial investment amount. So while the cap rate is the ratio between the investment amount and the first year net operating income, the internal rate of return is the cap rate plus any growth to the asset and its income stream. Sometimes investors will purchase properties with a cap rate that is lower than their desired rate because they anticipate growth.
[{"id": "cwcr4yo", "text": "no - no just no, did you study for real estate at all?  Cash flow vs value. ", "replies": [{"id": "cwcts6s", "text": "So what portion is inaccurate? I appreciate the help...", "replies": [], "depth": 2}, {"id": "cwcv1ed", "text": "Quote from our own sidebar regarding cap rate. \"...is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.\"\n\nWhat is inaccurate?  ", "replies": [{"id": "cwdfed8", "text": "that is accurate.  No one buys or evaluates RE based on a 1 year investment period.  That is the problem with OP's original post.  It seems to indicate that if you want to do anything beyond 1 year caps aren't useful.", "replies": [{"id": "cwdkzah", "text": "Correct me if I'm wrong, but when you say \"Building A sold at a 7.5 cap\", you are talking about the cap rate based on the NOI and value at the time of sale.\n\nSo from the buyers perspective, this is generally year 1's NOI.", "replies": [{"id": "cwdl8e0", "text": "What time of sale?  The past year?  The proforma next year?  \n\nI'm looking at a property now where they just signed a 10 year lease with 6 months abated.  Do you think most buyers would half the cap for that?  How does that make sense?  \n\nNo you use stable values generally.", "replies": [{"id": "cwdp7wm", "text": "Suppose Building A has been 33% vacant for the past 10+ years, with the other 66% occupied by a credit-worthy corporate tenant. A new buyer comes in with big plans for capital improvements to retain the corporate tenant and eventually lease the remaining 33% to a new tenant. Current NOI is $1,000,000 but projected NOI after improvements being $1,500,000 (*projected*). The buyer purchases the property for $10,000,000. So would this property have sold at a 10 Cap or 15 cap?", "replies": [{"id": "cwdrh13", "text": "15", "replies": [], "depth": 7}, {"id": "cwdrkpd", "text": "It get more complicated than that with cap improvements but closer to 15 than 10.  You wouldn't ignore the vacant space", "replies": [], "depth": 7}], "depth": 6}, {"id": "cwi9t2e", "text": "We forecast cap rates over the entire hold using the pro forma when looking at a purchase.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "cwdeijw", "text": "Hey Id love to know what triggered you, because while I feel I have a good grasp of these concepts, based on your reaction I am not yet explaining well and clients ask me about these concepts all the time. Did you not like the use of the word purchase price and/ investment amount instead of the word value? Isn't the price that someone pays for it the current actual value? I could see using market value in marketing, but from an investor perspective, Id use the amount I plan to pay for the asset as value. \nOr perhaps expressing a cap rate as the rate of return on ones investment (purchase price) in the first year. I want to find a better way to express that as a relationship/ratio/percentage because that is definitely a poor choice of word. \nI wanted to keep IRR very simple, because I think trying to get into discount rate and net present value is overkill in what I'm trying to do. I'm trying to explain one or two concepts or a comparison of two concepts in just about a paragraph so that it's just a little bit of reading, and very understandable. When you can, let me know. Thanks for the help. ", "replies": [], "depth": 2}], "depth": 1}, {"id": "cwctgrh", "text": "Great to want to contribute to the company but this is not accurate at all. I'd start with a site like investopedia.com or something to gain a basic understanding of these concepts before you try to write about them.", "replies": [{"id": "cwctqzm", "text": "So just to help me out, what is inaccurate? I just finished CCIM so I'd really appreciate it. ", "replies": [{"id": "cwctw0d", "text": "not to say that I know, I'd just really like to learn where I'm wrong. ", "replies": [{"id": "cwcw1k0", "text": "Hey there,\n\nSo you are correct on cap rate. That being said, I do not the it is a very great explanation of cap rate.\n\nTo me the cap rate is the ratio of Year 1 net operating income (NOI) to the purchase price expressed as a percentage. Therefore, when cap rates for a particular property type or geographic location and compressing (i.e. lower cap rates), this implies that investor/buyers are willing to pay a greater purchase price for the same NOI. An example being if NOI = 100 and purchase price = 1,000 the cap rate would be 10%. If the purchase price doubled to 2,000, the cap rate would now be 5% (100/2,000). Investors may be willing to pay a lower cap rate for the same amount of NOI, as in the example, for several reasons all of which have to do with value creation. Value creation could be through general appreciation, value created through renovations/capital projects, or maybe there is a lot of leases that expire soon that can be signed at higher rents than the current leases.\n\nWhat is important to note, is that cap rate only looks at Year 1 NOI. It tells you nothing about the future performance of the property. It is purely a snapshot in time. \n\nThe internal rate of return (IRR) is what you call a money-weighted measure of return. In order to understand IRR you need to understand the concepts of the time value of money and the net present value. Hopefully you have these concepts down, if not, I'd look to youtube for some educational videos.\n\nBut essentially what IRR is, is the discount rate that than when applied to the cash inflows and outflows of an investment achieves a net present value of zero. If an investment's IRR is greater than the required rate of return of the firm or investor, than you should investment in the project. \n\nIRR and cap rate should be thought of as separate measurements. IRR looks at the entire investment horizon whereas cap rate looks only at year 1. ", "replies": [{"id": "cwddcbh", "text": "Thanks. In this situation our plan is to express to someone who is tracking comps what the cap rate is, so that fewer mistakes are made. So when this employee is making entries, if this employee sees NNN as 30.00 per foot or a cap rate as 3,000% they will think to get more information instead of posting. I would like to eventually incorporate discount rate and comparing present value depending on annual cash flow, positive and negative leverage, etc but my initial want was to make concepts that people hear all the time as simple as possible. But because there is so much behind these concepts and because the verbiage is so specific, it's proving tough. So while in CCIM we did compare NOI to value, we also used the word purchase price a lot. Not incorrect, but I think it really threw the first two responders. I'd really like to know if that was the portion they took issue with. And perhaps comparing cap rate and irr isn't important for this purpose, but I wanted to express that the cap rate shows the initial year, used for prospecting, and IRR Is more about the return during the holding period, and it is the growth, cash flow, appreciation period over the term including the disposition. And also can be a discount rate to find present value, or what one should pay upon investment for the projected cash flow and disposition amount. Another thing I'd love to explore is the space market versus capital market, market rent compared to supply and demand, accumulated capitalization. Thanks and let me know any thoughts you have if you don't mind. ", "replies": [], "depth": 5}, {"id": "cwde373", "text": "I like the term snapshot. Like comparing a balance sheet and long term income statement. ", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "cwcwroc", "text": "A capitalization rate is used in the approach to value called direct capitalization. It is the relationship between one year's stabilized NOI and value. It implicitly considers expected growth in cash flow and property value in perpetuity; thus, it gives a return on and a return of capital. The internal rate of return (IRR/discount rate) is used in a discounted cash flow model (DCF). The IRR effectively discounts the cash flows to today's dollars (return on capital), while a terminal capitalization rate determines the value of the property at the end of the holding period (return of capital). There is a relationship between the IRR and the capitalization rate called the property model... this is a little tricky though and probably very tricky to explain over reddit, in the dark, without a backlit keyboard ;-)", "replies": [{"id": "cwdbw9f", "text": "this one.  DCF attempts to isolate different streams and factors (for example you can choose the discount rate, appreciation, etc).  Cap modelization DOES includes appreciation, economic uncertainty, an appropriate discount rate etc, it is just all IMPLICIT because you are working with market values where these things are defined by the market.   \n\nThis is simplifying it, but CAP = good for looking at where a property is in the market.  IRR = good for looking at where a property is inside of your investment strategies and general assumptions for your portfolio.  \n\nTo say a cap rate is only about first year income and misses everything else is not understanding it and simplifying it though......", "replies": [{"id": "cwddrzm", "text": "I see what you mean when comparing EOY1 NOI with market value but I've been expressing as purchase price as well. But when comparing with market price then yes; then it is dictated by many elements other than first year NOI. But in the classes I've taken, the purchase price has been the value because the investor is using what they personally would pay for the property, not necessarily the market price. What is your thought on that? I guess that is more appropriate in a market with inventory; in which one could easily negotiate. ", "replies": [{"id": "cwdf2yd", "text": "I think that is the issue.  You are trying to combine two things.  \n\nThe purchase price may be the market price, or it may not be.  The market cap will encapsulate all the things mentioned.  The IRR may or may not.  It is much more customization and can allow for your COC or personal costs to come into play.   \n\nFor example say I rehab apartments.  I'm looking at a property that needs a complete rehab.  The market price for the property will tell me the cap (or more commonly the market cap will tell me the market price) then an IRR type analysis where I look at what it actually costs me to pay my guys, buy materials, do a lease up etc will tell me what my actual return will be.  When I look at what it costs me to borrow money, make payments, do construction, lease up etc IRR is a much much better metric to say if I want to do this.  My situation is mine though.  Maybe some people do this better, or worse.  What my return is in no way defines its value to anyone but me.  \n\nDoes that make sense?  A cap probably is better at determining market value, an irr is better at determining what it is personally worth to me.  \n\nIf you are using caps to say \"oh i get a 5 cap on this one, and a 6 on this one, and a 7 on this one\" you are probably doing it wrong.  A better approach is to say \"this specific property seems to most likely be a 7.5 cap property\"  then you can bust into IRR around that number and say \"ya know when I figure out how this will work for me, its great, or the return just isn't there\".  ", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "cwddlbf", "text": "Very true. And my goal was to make the comparison as simple as possible, but without including present value so I can see where there is not enough information. The verbiage is important too because I think my use of the word purchase price or initial investment threw people because the word value is so often what is used. But I haven't found the word purchase price to not be used in cap rates, but good to know the words that trigger people. And I should have been more clear that I'm trying to make this for people who hear these words and have no idea what they mean. Thanks for the help. ", "replies": [{"id": "cwe185h", "text": "Some of the comments here are completely wrong. I'm a commercial real estate appraiser; I've taken the Appraisal Institute's Income 1, 2, and advanced income, and I'm about 6 months away from the MAI designation. I run DCF and direct cap models on a weekly basis, for a wide variety of property types. There are a few different ways to arrive at value via income capitalization. Direct cap is the most basic. It projects income and expenses for the first STABILIZED year and then uses an OAR to convert that income into a market value. This method, in theory, accounts for growth both in rent and property value, IN PERPETUITY. Property isn't stabilized? Run the pro forma for the stabilized year anyway and make an adjustment to the value to bring the property to a stabilized level of occupancy. Property leased below market? Above market? You can adjust for that. This is the correct way to arrive at value. This is why it is imperative to understand the circumstances surrounding each. and. every. sale. If a property sold at a 7% OAR and you're thinking, well shit, it should have gone for 7.5%, what's the deal? It could be because the broker is reporting the cap rate based on current income, and it is not stabilized. A lower than typical OAR shows upside potential. The DCF does the EXACT SAME THING as the direct cap!, it just does it a different way... running it over a projected holding period and using a few more assumptions. This method separates out the return on your capital (the discounted flows of NOI each year over the holding period) and the return of your capital (the sale of the property at the end of the holding period - the reversion/uses terminal capitalization rate) - you have to come up with discount rate, terminal cap rate, growth projections, etc. Direct capitalization (using capitalization rate/OAR) is more widely used because it is much easier to understand and there is usually readily available market information (sales of similar properties). DCF is used by sophisticated investors... and nerdy appraisers.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "cwd1b48", "text": "Cap rate is not necessarily measured based on year 1 NOI. If you have a multi-year lease-up on a property, you may measure it based on stabilized NOI (since you are most likely concerned with as-stabilized value of a property). \n\nSimple stated, cap rate is just the relationship between stabilized NOI and value in a direct capitalization scenario.\n\nGood luck! ", "replies": [{"id": "cwdc03t", "text": "yeah this is why terms like 'going in cap rate' and 'actual cap rate' exists....... \n\nWhich may be good things for OP to add to this blog to help describe what cap rate is and why it is not as simple as \"well its going to make 10 bucks this year and costs 100 so the cap is 10!\"\n\nAlso a cap rate is not a rate of return.  Strike that from your blog thing.  ", "replies": [{"id": "cwde13l", "text": "Thanks. I'm thinking I'll use the ratio between the first year net operating income and the value or purchase price of the property. ", "replies": [{"id": "cwdeun2", "text": "ratio is the correct word.  Its sounds stupid but when I was in school our department head taught our dev classes.  She has done probably a billion in projects so I'm not trying to make this sound academic.  If we called cap rate a percent or a rate of return we got points off.  It is a ratio.  When I was hired where I am now my boss called me at like 8pm and said he wanted to make a decision between me and another person by tomorrow.  Financial knowledge was important to our brokerage.  He asked me to explain what a cap rate was, what a discount rate was, and why they are different.  That is very very similar to the question you are writing a blog about.  \n\nAnyhow for folks that do this shit the problems with your entry is immediately apparent and the kind of thing that would be corrected quickly for new agents or with investment clients.  Maybe i'm too specific because of how I was taught, but as someone who has worked in the investment space since the late 2000's I'd immediately correct that if one of our new agents wrote it and explain what I've said in this thread.  Most of the other posters here seem to have the same thoughts too", "replies": [{"id": "cwdfsqv", "text": "Thanks. That absolutely makes sense. ", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "cwdbkxr", "text": "Google built up cap rate model.  \n\nThat should help you understand some of what people are bitching about", "replies": [{"id": "cwdeplr", "text": "Thanks. I'll check it out. ", "replies": [], "depth": 2}], "depth": 1}, {"id": "cwl3c43", "text": "I describe Cap Rate as a shorthand approach to compare investment properties and the market trends in general. It's the ratio of net income and sales price. I also tell them it's not the way to fully analyze the investment, and explicitly indicate many of the biggies Cap Rate is \"Blind\" to. \n\nWhen I am presenting I sometimes show a top tier credit asset with long term lease, and contrast with an equal net income property with short term leases and horrible tenants. Ask them which they'd pay the most for (and the answer is obvious). It's an easy way to kick off the conversation about Cap Rate and risk, etc...\n\nIRR is a different animal, better and more descriptive, but also containing assumptions that are likely off to some degree or another (exit pricing assumptions, lease-up and renewal assumptions, etc) \n\nInvariably, sellers will ask what cap rate their building is... which we can't tell until we take it to market (although we have a good sense based on comps) Heck, even a motivated seller can drive a lower cap than we might expect it to otherwise close at front-end.", "replies": [], "depth": 1}]