Analyzing Cap Rates

Analyzing Cap Rates

Structures capitalization rate analysis with market comparison, risk premium decomposition, and trend assessment.

When To Use

• Evaluating acquisition pricing against market benchmarks for a specific property or portfolio
• Comparing yields across property types, geographies, or vintages
• Decomposing cap rate movements into risk-free rate, credit spread, and property risk premium components
• Assessing whether observed cap rate compression or expansion reflects fundamentals or market sentiment
• Supporting underwriting assumptions in investment committee memos or REIT portfolio reviews

Inputs To Gather

• Subject property NOI: Trailing-12-month and forward-year stabilized NOI; confirm whether above-the-line or below-the-line capital reserves are deducted
• Transaction price or appraised value: Source and date; note whether price reflects gross or net of closing costs
• Comparable transactions: Minimum 3-5 comps with sale date, property type, location, size, occupancy, and confirmed cap rate
• Risk-free rate benchmark: Current 10-year Treasury yield as of analysis date [VERIFY current rate]
• Market surveys: CBRE, JLL, NCREIF, or RCA cap rate reports for the relevant property type and MSA [VERIFY data vintage]
• Lease and occupancy profile: WALT, credit quality of tenants, rollover schedule, and in-place vs. market rent spread
• Property-specific risk factors: Deferred capex, environmental issues, entitlement risk, single-tenant concentration

Workflow

1. Calculate the subject cap rate

   • Going-in cap rate = Stabilized Year-1 NOI / Purchase Price
   • Terminal (exit/reversion) cap rate = Projected NOI at exit / Assumed sale price
   • If both are provided, confirm the implied spread between going-in and terminal rates (typically 25-75 bps expansion for standard hold periods)

2. Build the comp set

   • Select transactions closed within 12-18 months in the same MSA and property type
   • Adjust for material differences: occupancy (normalize to stabilized), lease structure (NNN vs. gross), and property quality (Class A/B/C)
   • Present comps in a table: address, sale date, price, SF/units, cap rate, occupancy, and key notes

3. Decompose the cap rate into risk premium layers

   • Risk-free rate (10Y Treasury)
   • General real estate risk premium (illiquidity, transaction cost, management burden — typically 150-300 bps over Treasuries for institutional-quality assets)
   • Property-type premium (e.g., office currently commands wider spreads than industrial) [VERIFY spread environment]
   • Location/market premium (primary vs. secondary vs. tertiary MSA)
   • Asset-specific premium (credit quality, lease term, physical condition, capex requirements)
   • Sum the build-up and compare to the observed cap rate; identify which component explains any divergence

4. Assess cap rate trends

   • Chart cap rate movement for the property type/MSA over 3-5 years using NCREIF, RCA, or survey data
   • Identify whether current pricing sits above, below, or at the historical mean
   • Separate rate-driven movement (changes in risk-free rate) from spread-driven movement (investor risk appetite)
   • Note supply pipeline and absorption trends that may pressure future cap rates [VERIFY local market data]

5. Stress-test key assumptions

   • Model cap rate sensitivity: show NOI value impact at +/- 25 bps and +/- 50 bps from base case
   • Test terminal cap rate assumptions against forward rate expectations
   • If vacancy or rent roll-down is material, show the impact on implied cap rate at stabilization vs. in-place

Output

Structure the deliverable as follows:

• Executive Summary: Subject cap rate, position relative to comps and market averages, key risk factors, and pricing assessment (fairly priced / tight / wide)
• Cap Rate Calculation: Show NOI inputs, price, and resulting going-in and terminal cap rates with formulas
• Comparable Transactions Table: Minimum 3-5 comps with adjustment notes
• Risk Premium Decomposition: Build-up table from risk-free rate through asset-specific premium
• Trend Analysis: 3-5 year cap rate chart or table for property type/MSA with narrative on drivers
• Sensitivity Matrix: Value impact grid at varying cap rate and NOI scenarios
• Limitations & Caveats: Data gaps, stale comps, or assumption dependencies

Quality Checks

• Confirm NOI definition is consistent across subject and comps (same treatment of reserves, TI/LC, management fees)
• Verify cap rate math: NOI / Price = stated cap rate (rounding errors are common in third-party reports)
• Ensure risk premium build-up sums to within 25 bps of the observed cap rate; if not, explain the residual
• Check that comp sale dates are disclosed and sufficiently recent; flag any comp older than 18 months
• Confirm risk-free rate and market survey data reflect the analysis date, not stale benchmarks
• Validate that terminal cap rate assumption is supportable — an exit cap tighter than going-in requires explicit justification
• Mark any jurisdiction-specific tax, zoning, or regulatory factors with [VERIFY] where they could materially affect value