The ‘CAP’ rate, or the capitalization rate, is an important metric for valuation and investment in commercial real estate. The Cap Rate of properties in a city or a micro markets should be assed carefully before making an investment in the commercial real estate stock there. Cap Rate is essentially the rental income potential of a commercial building and is arrived at by dividing the net operating income (the rental minus the expenses) by the sale price of the building.
Cap Rate= Net Operating Income/ Current Market Rate Of the Property.
In other words, Cap Rate is the ratio of Net Operating Income (rentals) to the asset value. For example, if the rentals earned by a commercial building is Rs 20 lakh per annum and the sale price of the building is Rs 1 crore, then the Cap Rate would be 20 percent. It is important to note that expenses on the rental income like taxes and maintenance costs must be subtracted from the rentals earning to arrive as Net Operating Income.
A Cap Rate, in some ways, lets an investor of a commercial property know how much returns will he or she get. So in the example given above, an investor will get 20 percent return on purchasing the building for Rs 1 crore in an all cash deal.
The Cap Rate can be impacted by the following factors:
1 Age of the building
2 Reputation and creditworthiness of the tenants of the building
3 Lease tenure of the existing tenants
4 Demand and supply dynamics of the micro market, especially of the same type for which the cap rate is being calculated
5 The emerging business scenario in that market
6 Macro fundamentals like population growth and employment opportunities in that state or region
A Cap Rate can be used to find out the earning potential from investment in a commercial property. Another use of the Cap Rate is to find out the value of a property, if the Cap Rate and Net Operating Income of the building is known. For example, if the Net Operating Income is Rs 25 lakh and the Cap Rate is 10 percent, then using the same formula, we can arrive at the valuation of the building which is Rs 2.5 crore in this case. In the second example, the investor can recover the investment in 10 years and the in the first example, the investor can recover the investment in 5 years. Thus, the higher the Cap Rate the lower would be the time to recover the investment and vice versa.
A Cap Rate can also be used to predict a particular property market and where it is heading. This is especially true for a micro market or a particular locality or street. A trend of the car rates prevailing in the last 5, 10 or 15 years can give a fair idea as whether the valuations are headed upwards or downwards. These trends can further help in taking a decision whether a certain property has to be acquired or not. If there is a falling trend in the Cap Rates, that means the valuation are going up in that micro market and the market is heating up. What will be the valuation in the coming years can be found out by using Cap Rates.
The Cap Rates can be useful in future valuation only when there is a clear historical trend. If there has been wild fluctuation in the rental incomes from one year to another then merely using Cap Rate to arrive at valuation may not work. There can be sudden variations in rental incomes in particular sub markets because of development of infrastructure in that area or some regulatory change impacting the business conducting potential in that locality.
Cap Rate versus ROI
Cap Rates and Return on Investment (ROI) are different metric and are often confused by the people. Care must be taken as when to apply Cap Rate and when to use ROI formula. For ROI, the mortgage payment is also taken into consideration. For calculation of ROI, we have to look at the ‘Cash Flow’ also. Cash Flow is the Net Operating Income left after taking out mortgage payments. In other words, Cash Flow is Net Operating Income minus the payments towards mortgage.
ROI is arrived at by dividing the Cash Flow by the Down payment for purchasing the building.
For example, if the Net Operating Income from a property is Rs 2 lakh and the EMI payment for loans is Rs 5,000 (Rs 60,000 yearly) then the Cash Flow will be Rs 1,40,000 (Rs 2 lakh minus Rs 60,000). The down payment for the building is, lets say, Rs 5 lakh. ROI in this case will be Rs 1,40,000 divided by Rs 5 lakh, that is, 0.28 or 28 percent.
ROI will let the investor know the true picture of the income by investing in a property if a loan is availed in purchasing the property. Cap rate is useful in cases where there is no financing or mortgage is involved and the property is purchased on self-financing basis.
Cap rate IN Indian Scenario
The Cap Rates in India are trending towards compression, that is, they have demonstrated a declining tendency over the last decade or so. This is because a number of private equity (PE) investors and international pension funds have been active in picking up property in India and that is causing the valuations of the property to go up.
The Cap Rate in the country has now come down to about 7.5-9 percent from about 11 percent that stood a decade ago. Property experts feel that the Cap Rates can further go down by around 1-2 percentage in the next 5-8 years, on account of heightened interest by foreign institutional investors taking the property valuations further up.
The property market in India has attracted PE investments worth USD 15.9 billion in the last two years in 2016-17 and 2017-18. Around USD 7.3 billion of the total USD 15.9 billion has gone in commercial real estate in the country.