Capitalization rates. One of the critical metrics used in evaluating new opportunities is called the capitalization rate or cap rate. It is the initial return expected on a property expressed as a percentage of the expected or forward net operating income from that asset over the purchase price or present market value of the asset. In Europe, this is referred to as the yield, but be careful in using this terminology as it does not represent the investor yield in the same way as an IRR does. When calculating cap rate, net operating income is used, which is defined as all building related income less direct property expenses, property taxes, maintenance repairs, et cetera. Since most valuation is driven by future earnings or growth, we want the next 12 month operating income or next fiscal year if next 12 month is not available. It is critical that these cash flows are unlevered as the current or proposed financing of the building should not impact the cap rate. As for the denominator, if the asset is being purchased, the price is generally established by the market. However, if the asset is already on the books and not currently for sale then real estate comps will need to be done to establish fair value. Do we want a high cap rate or a low cap rate? Let's take a closer look to see if we can understand the metric better. If we take our cap rate formula which is essentially a yield ratio and invert it, we get a multiple of the property value over the earnings. We recognize this kind of multiple from other valuation multiples such as a PE or price to earnings multiple which is the value of a company's equity over its earnings. It's also similar to an EV to EBITDA multiple, which is the value of the entire enterprise over its earnings. As an inverted formula in its multiple form, it is easy to see the relationship between the value and the earnings. The higher the value of the building, the higher the multiple, therefore the lower the cap rate. So now we see that lower cap rates mean higher multiples of earnings paid for the building. What contributes to a higher or lower cap rate? Here's an example of a building investment cycle. Here we have a developer buying a high cap rate building, investing in it, and making a bet on the area improving, then achieving a lower cap rate, higher multiple on exit. Just like with PE and EBITDA metrics, there are two things that can be affecting the multiple, the earnings and the value. High multiples might reflect bidding wars for hot properties, but they can also reflect high prices paid for underperforming assets. The same works in reverse. In theory, market pricing should solve these issues, but in real estate, the trends can take a while to unwind. The cap rate on acquisition is referred to as the going in cap rate and the cap rate on exit is the exit cap rate. There are many factors both in the control of the developer and out, which might affect the difference between the two.

Cap rates are driven by many factors. Factors that lead to the growth or the demise of an area have many causes. Some could be related to legislation, some to demographic trends. Secondly, each building sector type carries its own risk. Retail, for example, under the onslaught of online retailing has risks that are different from offices or industrial buildings. Whatever the trends are at a given moment will be reflected in the cap rates. Property classes are ranked by letter with A being the most desirable. These are the highest quality buildings in their market and area. They're generally newer properties built within the last 15 years with top amenities, high income earning tenants, and low vacancy rates. Class A buildings are well located in the market and are typically professionally managed. Additionally, they also demand the highest rent with little or no deferred maintenance issues. Class B are a step down and may require maintenance. Class C are older buildings in need of maintenance with less desirable leases or in less desirable markets. Leases themselves are classified as net, double net, and triple net. Double net is sometimes referred to as a modified gross lease and net is sometimes referred to as a full service lease. In triple net leases, taxes, maintenance and insurance are passed on to the tenants as an additional charge over the rent. The landlord usually handles structural issues like roofs, but those can also be included in the expenses. A modified gross lease typically binds the landlord to pay the real property taxes, insurance and common area maintenance while the tenant takes responsibility for its own utilities, interior maintenance, and janitorial services. In a full service lease, just as the name implies, the lease covers all or almost all of the operating expenses in the lease. Some of the few exceptions are telephone and data expenses. Otherwise, the landlord pays taxes, insurance, common area maintenance, interior maintenance, janitorial utilities, and so on. As a result, these rents are usually the highest. These types of leases usually occur in large multi-tenant office buildings where it is too difficult or cumbersome to divide up the expenses among tenants. Let's look at an example of cap rate disparities. Property One is a tried and true investment with little risk. It is fetching a high multiple as a result. Property two is an up and comer that requires some investment and will also most likely require some time to stabilize. Because of this, it's cap rate is harder to calculate, but we know that it's definitely higher than property one. Therefore, we begin to see how cap rates act in a similar way to cost of capital. They reflect the risk of the overall building.

As management considers new projects, it must be certain to choose projects that have an expected return, which is measured by the cap rate that is greater than its cost of capital. In this context, the cost of capital is the expected return by the holders of the debt and the equity. If buildings are acquired that have an expected return less than the company's cost of capital, the returns to the stakeholders will suffer. New capital will be cut off as investors turn to other buildings or other assets with better returns. As important as the cap rate is, it is important to understand its limitations. First of all, cap rate does not factor in several things like capex, tenant improvements or leasing commissions. Second, to calculate a cap rate, we have to have an estimated value of the building. If we're buying a new building, this is the selling price. If we're valuing our existing buildings, it becomes more complicated and we need to use comparable building values or comparable building cap rates. Lastly, cap rate represents a very near term valuation as it only factors operating income from the next year.