What is a Cap Rate?

Cap rate, short for capitalization rate, is a measure of profitability of a real estate investment. More simply, it is how much of the value of a property an investor is receiving as profits. Cap rate can be a measure of how risky an investment is. The higher the cap rate, the higher the level of risk, and the higher the expected profitability. Simple finance. And the lower the cap rate, the lower the risk, as well as expected profitability.

What Are Cap Rates Used For?

• Real Estate Valuation: The value of a property = NOI / Cap Rate. Appraisers often employ this method to determine valuations by using cap rates from similar properties.

• Property Comparisons: Capitalization rates should be the same for properties around the same area with similar conditions, usage, and risk profile. If there is a difference in cap rates for similar properties, it could be due to mismanagement, under-renting, or another opportunity for a value-add scenario.

• Returns Analysis: By definition, a capitalization rate is the rate of return that you can expect from a property after considering all income and actual expenses.

• Market Analysis: The strength of a specific real estate market is reflected in the cap rates of the area; the lower the cap rate, the stronger the market (because properties are in higher demand).

What are the Limitations on Cap Rates?

Cap rates are useful for many purposes, but there are some circumstances on which their accuracy cannot be relied upon in order to make financial decisions. The following are a few circumstances where cap rates may not be useful to a real estate investor:

• Special Use Properties: Because special use properties are designed for a specific business or function (i.e. car wash, church, auto repair, etc.), it is sometimes difficult to find enough direct comparables to establish a dependable cap rate across that asset type.

• Small Markets: Because small markets have less properties and therefore less sales, there is a smaller pool of comparables to choose from when looking at the cap rates; it may lead to using properties that may not be recent or direct comparables, but rather “adjacent” to what you’re looking for, causing misleading cap rates that may not accurately reflect the current market.

• Operating History: If a property has an inconsistent or unknown operating history (i.e. income and expenses) or is an owner-user property, it would be very difficult (if not impossible) to come up with an income and expense projection that could be applied to a cap rate, which would make it hard to determine a definitive valuation.

It is important to keep in mind that the capitalization rate ratio can be very useful for helping determine whether or not a property is worth continued diligence, but it should not be the only thing that a real estate investor should rely upon when considering the purchase of a commercial property.

What is a Debt Service Coverage Ratio (DSCR)?

The debt service coverage ratio (DSCR) is the ratio of cash accessible for servicing a loan or an entity's debt. It is used to measure an entity's capability to pay off a loan. A higher ratio makes it easier to obtain a loan. Commercial lenders use a minimum DSCR as a loan requirement. Most conventional loans require a DSCR of 1.2x or higher.

What is the Difference Between Debt Yield vs. DSCR?

DSCR is the net operating income divided by the annual debt service (i.e. mortgage payments). Contrary to first glance, the debt service in the DSCR formula is not necessarily a static input. This input can potentially be shaped by lowering the interest rate used in the loan calculations or extending the amortization period for the potential loan. For example, if a loan is unable to reach a 1.25x DSCR at a 20-year amortization, it is possible to use a 25-year amortization to decrease the loan payments, thereby increasing the DSCR. Increasing the amortization period has the effect of the monthly loan payments, but also decreases the principal paydown, which increases the overall risk profile of the loan. However, this additional risk is not readily apparent while using LTV or DSCR.

What is Cash on Cash (CoC) Return?

Cash on Cash (CoC) Return is another real estate tool which measures the relationship between cash invested and the cash flow, or net operating income of a property. CoC return measures the annual return on investment.

Uses of CoC Return

CoC return is an indicator of an investment’s performance; that is, how well an investment is doing. CoC can also be a way to forecast future cash flow returns on the property. CoC, very much like cap rates, can be used to evaluate how an investment is doing and whether it’s improving or not.

Cap Rate vs. CoC Return

It’s important to mention that if you purchase a property with all cash, the value of CoC will be the same as the value of the cap Rate. To understand, go back to the denominator in each formula. If you do not use a loan or put down a down payment, if you pay in cash at the time of the purchase, then both denominators will be equal to the price of the property (investment), and there will be no difference between cap rate and CoC return.

So where does cap rate differ from CoC return?

There are three main differences between cap rate and CoC return.

• If you do not purchase in all cash, the denominator in each equation will be different. It will be purchase price in cap rate calculation, and cash investment for CoC return.

• While CoC return considers the annual financing costs for the property, also identified as the annual investment, cap rates do not. So when calculating cap rate, you should never include any financing costs such as mortgage cost.

• Financing costs are included as an expense in the calculations of CoC return, but they are not in the calculation for cap rate.