HSA Weekly Report: From the Intern’s Desk - Part One
What is a Cap Rate?
When evaluating real estate deals, one of the most prevalent metrics is the capitalization rate, more commonly referred to as a “cap rate”. Cap rates are calculated by dividing the net operating income by the value of the property (NOI / Value).
I.E., $100,000 NOI / $1,000,000 Value = 10.0% Cap Rate.
Cap rates are pivotal to evaluating deals as they are a real time analysis of a property’s ability to generate cash flow. However, it is important to note that cap rates are typically used as an apples to apples comparison without factoring in debt service. More in depth forward looking calculation typically featured cash flow projections and internal rate of return (IRR).
There are a multitude of ways to derive cap rates and it’s vital to identify which type of cap rate is being used. Different types of cap rates exist such as: Pro Forma, T12, Adjusted for Taxes and Terminal or Exit rate.
Pro Forma: Assumptions surrounding a property’s income and expenses for the next 12 months.
Pro formas cap rates are more frequently used for value-add deals when projecting income and expenses, or in the absence of other necessary data. Thus allowing income or expenses adjustments and frequently includes assumptions around the NOI that inorganically increase/ decrease the NOI.
T12: A statement of the property’s trailing 12 months Incomes and expenses.
T12 caps are usually more true to the property’s performance because it uses the physical NOI without any assumptions or adjustments in the calculations. However when using T12’s it may include extraordinary CapEx or Incomes that otherwise would not have occurred in any given year, still affecting NOI.
Adjusted for Taxes: Calculating the projected taxes after property value reassessment.
Oftentimes a pro forma or T12 cap rate can be misleading if the purchase of the property far exceeds the current assessed value. Adjusting for the future increase in taxes is a way to normalize the cap rate.
Terminal Cap: The projected NOI for the year following the sale of an asset divided by the projected sales price.
Terminal cap rates, also known as exit rates, are used to see what the status of a property will be after the estimated holding period. However, it is smart to create several terminal cap rates based on different sets of assumptions. Such as: Likely to occur, worst-case scenario, and best-case scenario.
