The capitalisation rate (cap rate for short), is the percentage, market-related return on a property investment (before the cost of debt funding and taxes).
Similar to a price earnings (PE) ratio for the valuation of equities (businesses), it enables an earnings-driven valuation approach in calculating the value of commercial real estate (CRE) assets.
Cap rate and yield are similar concepts, both are percentages. As with a PE ratio, a cap rate provides a market indicator reflecting market conditions and risk specific to that asset. Yield is reality – the actual return on a concluded deal: annual net income / property purchase price x 100.
Annual net income equals one forward-projected year of earnings, with the first month (of twelve) starting from the anticipated transfer of ownership date.
Example: a property, from presentation of the sales packs, will take an anticipated 4 months to transfer. Therefore the annual net income for purposes of calculating the property value will be the net income of months 5 to 16.
- A property is pushing out R10M per year in net income
- The property’s sales price is R100M
- The capitalisation rate on properties of that specific nature is deemed to be 9.5% (This results in a cap rate-driven valuation of R105.3M (R10 ANI / 9.5% cap)
- The sales price is achieved. The calculated yield on that property is 10% (R10M ANI / R100M purchase price)
- That same property pushing out R10M per year’s price is negotiated down to R80M in a sale
- The yield on that property is 12.5% (R10M ANI / R80M purchase price)
- The provided capitalisation rate was 9.5%.
- Conclusion: given enough data points confirming that the cap rate is too light, the cap rates appears to be out of kilter with market
In summary: the lower a cap rate or yield, the more expensive the property.
Where it can get confusing
So, for a property pushing out R10M in annual income, if a seller can sell it at a:
- (low) 5% capitalisation rate or yield –> the seller will achieve R200M (calc: R10M / 5%)
- (high) 15% capitalisation rate or yield –> the seller will achieve R66.7M (calc: R10M / 15%)