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Leveraged Breakdowns

Cap Rates – Textbook vs. Street

One of the things you will learn as a real estate private equity beginner is that many industry terms are both simple and complicated. In speaking of cap rates, what we mean is that cap rates have an “everyday” application that is intuitive and simple. Its foundation, however, is much more complicated. As you move toward a career in real estate private equity, you will need to learn to use cap rates in their simple form. But to quote Captain Kirk, “You have to learn WHY things work on a starship.”

What is a Cap Rate?

The term “cap rate” is short for “capitalization rate.” The term is defined in real estate appraisals, as the market rate of return for the property being appraised (see more on appraisals here). Appraisals break the cap rate down into three distinct parts: the risk-free rate, the equity rate, and the debt rate. The sum of these three rates becomes the capitalization rate used to arrive at the property value based on the income approach (specifically, net operating income divided by the cap rate equals the property value).

So, I have to calculate all of that?

No, that’s the complicated part. The formula that the appraiser ultimately uses is really the shorthand that you need to know: NOI / Cap Rate = Value. Appraisers go through the longer process to arrive at an independent determination of the cap rate, which changes over time and as market conditions warrant.  As a REPE professional, the shorthand is what needs to become second nature. To work on this, you can practice using cap rates with our real estate investment analysis online course.

Keeping it Simple

To really make it simple, think about a cap rate in terms of it representing the unlevered return for an investment. If you flip the formula around, you have NOI / property value = cap rate. Now the focus is on the resulting cap rate, and that cap rate becomes the shorthand that allows you to compare one property to another. You’ll hear conversations around the office like this: “Can you believe they bought that warehouse at an eight-cap? They stole it!” Or, “That guy is asking for a four-and-a-half cap on a Chick-fil-A–apparently he doesn’t really want to sell it.”

Cap rates can vary widely across property types (discussed in detail here), across investment strategies (discussed in detail here), and across geography. It will take time for these nuances to become second nature, but the formula should be intuitive, such that you are able to do the math in your head very quickly. This will be critical in a job interview. For example, you may be asked what a property is worth if it has NOI of $3,000,000 and trades (sells) at a 5-cap. Sixty million should come out of your mouth before you really even think about it (thirty divided by 5). If the thought of this intimidates you, you should strongly consider our real estate investment analysis online courses for practice; it is designed for real estate private equity beginners!

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