Capitalization rates. One of the critical metrics used in evaluating new properties 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 the 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 IRR. When calculating cap rate, net operating income is used, which is defined as all building related income less direct property expenses, property taxes and maintenance and repairs. 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 earnings or 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, then the price is established by the market. If the asset is already on the books or not currently for sale, then you will have to do real estate comps to establish a fair value of the asset. 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 and invert it, we get the multiple of the property value over the earnings. We should recognize this kind of multiple from other valuation multiples such as PE, or price earnings, which is the market value of a company's equity over its earnings, as well as EV to EBITDA, which is the enterprise value over its earnings. As an inverted formula in its multiple form, it can be easier to see the relationship between value and earnings. The higher the value of the building, the higher the multiple, and therefore, the lower cap rate. For example, if a building has forward operating income of 1,000, property value of 20,000, the cap rate would be 5%, 1,000 divided by 20,000. Or we can say that the building is trading or selling for 20 times earnings, which is one over the cap rate, one over 5% or 20,000 over 1,000. So we now see that lower cap rates mean higher multiples of earnings and higher cap rates mean lower multiples of earnings. What then contributes to a higher or lower cap rate? Here's an example of a building investment lifecycle. A developer buys a shopping center with many vacancies in a quiet area. The purchase price is five million and the cap rate is established at 9%. Over time, he works to attract great tenants, add services and parking and benefits from a housing boom in the area. When he goes to sell the property, the selling price is 30 million and the cap rate is now 5.5%. The developer has effectively driven the cap rate down by driving the value up. Now, how did the developer drive the cap rate down? Well, effectively by increasing the income generating ability of the asset. Just like with PE and EV to EBITDA metrics, there are two things that can be affecting the multiple. One is the earnings. Two is the value of the assets. High multiples might reflect bidding wars for hot properties but they can also reflect high prices paid for underperforming assets or assets that are not generating enough revenue. 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.