The Cap Rate - Part 2: What It Is, What It Does

In an earlier posting to this blog, we introduced the concept of the capitalization rate or cap rate, and discussed the basics of it. This discussion will expand on that discussion.

Simply put, the cap rate measures the return on total capital invested in an income-producing property in any given year of operations. Total capital invested means all equity and all debt utilized in the deal. It also can be used to determine the market value of such a property.

There are three components to the cap rate: Income; Rate; and Value, which combine to form the acronym IRV. Income generally is net operating income or NOI. It is derived from Gross Income (expected income from all sources). First, loss of income from vacancies is subtracted, then credit losses are subtracted. This leaves Gross Operating Income (sometimes referred to as Adjusted Gross Income), or the funds generated by the property available for use by the owner.

Operating Expenses, or OPEX, are deducted from Gross Operating Income. This results in Net Operating Income (NOI).

Thus, expressed a little more clearly, the components of IRV are:

I = NOI

R = return on capital invested in any given year of operations, or the hurdle rate sought by investors

V = the market value of the property, given the NOI and hurdle rate

If you know any two of these components, you can calculate the third, as follows:

I = V x R

R = I ÷ V

V = I ÷ R

What’s reflected above is the overall cap rate. But this is a little more complicated than it appears to be at first blush. Because the overall cap rate measures the return on all capital invested, it consists of a lender’s component and an investor’s component. The lender’s component is known as the Lender’s Average Weighted Cost of Capital (WACC). The Investor’s component similarly is known as the Investor’s Average Weighted Cost of Capital.

The lender’s WACC is calculated as follows:

Mortgage Constant, depicted as the Greek letter kappa or К (i.e.,  Annual Debt Service ÷ Original Principal Balance of the Loan)

x Loan-to-Value Ratio (relationship between total cost and the loan amount, aka LTV)

= Lender’s WACC

Example:  LTV = 70%; К = 8.25%, then the Lender’s WACC = .0508 or 5.08%

The investor’s WACC is calculated as follows:

Investors’ % of the investment (the equity portion of the deal)

x Investors’ hurdle rate (investor’s minimum acceptable rate of return)

= Investors’ WACC

Example: Investor contributes 30%; Investor seeks 9% minimum return

Investors’ WACC = .0270 or 2.7%

So the overall cap rate is:

Lender’s WACC (.0508)

+

Investors’ WACC (.0270)

Cap Rate = .0778 or 7.78%

So, what does all this really mean? The first year’s cap rate has to equal or exceed 7.78% for all parties to achieve their goals. Thus, the current year’s NOI, when divided by the purchase price (value), has to equal or exceed 7.78%.

The third and final installment on cap rates will explore its flaws and what’s been happening to cap rates in recent years.

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