real estate split

What the Cap Rate from Real Estate Teaches Us about Investing

real estate split

The capitalization rate (or cap rate) on a real estate investment property is defined as its yearly net operating income (NOI: income after operating expenses, but before income taxes and interest) divided by it the price of the building. In other words, it's rate of return. A property may generate its gross income or revenue from rent, parking and servicing fees. A property's operating expenses include property maintenance costs, insurance, utility costs, property taxes and janitorial expenses. For example, suppose we have two hypothetical apartment buildings, both of which recently sold for $10 million. The first one (Building A) is in a less desirable neighborhood and has projected NOI of $1 million (or a 10% cap rate), and the second building (Building B) is in a nicer neighborhood and has projected NOI of $0.5 million (or a 5% cap rate).

Your first inclination might be to say that the buyer of Building A got a really great deal because that buyer is expecting $1 million in net operating income versus $0.5 million for Building B at the same purchase price of $10 million. What is going on here and why would someone pay $10 million for one half the net operating income? If you think one deal is better than the other, this might indicate that you are new to investing, because that would be like looking at return without considering the risk or thinking you have found a free lunch (see TANSTAAFL).

Ignoring the many sources of RISK inherent in a property, such as NOT getting the same income in the future due to changes in the occupancy rate or the neighborhood becoming even LESS desirable, would be a big mistake.

There are many legitimate possible explanations for the differences in the cap rates among properties. The most well known is, of course, location, location, and location. Buildings in less desirable neighborhoods can be rightfully expected to have more risk or uncertainty associated with the future income, resulting in lower prices of the buildings and therefore higher cap rates. The two buildings may also have differing amounts of expected rental income for the near term, but the building in the nicer neighborhood with $0.5 million of rental income may be expected to have less risk of receiving that income and a higher growth rate of the rents in the future. This is the classic risk-return tradeoff where return seems fairly easy to quantify, but the risk, or uncertainty of that return, is much harder to quantify.

These risk factors, as well as many other factors, have gone into setting the current price and will go into setting a future price between a willing buyer and willing seller (also see the efficient market hypothesis). That fair market value is also referred to as the equilibrium price where supply equals demand. The current price of the buildings should include multiple risk factors associated with the property. The higher cap rate of Building A (10% cap rate) may very well suggest that its buyer requires a higher expected return for bearing the higher risk of the less desirable neighborhood, as compared to the lower risk and lower cap rate of Building B (5% cap rate).

The table below summarizes the situation with the two buildings. 

Tale of Two Hypothetical Apartment Buildings
Investment Neighborhood Risk Value of Building Net Operating  Income

Cap Rate and Net Operating Income Yield

Apartment Building A Less Desirable High Risk
(High Cap Rate)
$10 million $1.0 million 10%
Apartment Building B More Desirable Low Risk
(Low Cap Rate)
$10 million $0.5 million 5%

If we wish to analogize this concept to two publicly traded companies, we may consider the idea that the market capitalization of a stock (the market cap = price per share times the shares outstanding), like the price a building, reflects risk factors associated with the uncertainty of future profits, cash flows, and even the geographic location of the company. To understand this concretely, let's consider two actual publicly-traded commercial bank companies, Sberbank of Russia (SBER) and BB&T (BBT) which is a US-domiciled bank.

The current market values of these two companies are quite similar at $28.2 and $27.4 billion, respectively, but SBER had $6.6 billion of earnings over the last twelve months while BBT had only $2.1 billion. Putting it in real estate terms, SBER has about three times the capitalization rate of BBT. However, when we consider the risks of investing in a Russian company (i.e. political and currency risk to name a couple), it is reasonable that SBER should be priced so that its investors are likely to be compensated with a higher expected return, which is indicated by its higher earnings yield (ratio of net income to price). The table below summarizes the current situation with the two companies.

Tale of Two Stocks
Investment Neighborhood Risk Market Capitalization Net Income Net Income Yield
Sberbank of Russia (Russian Bank) Less Desirable High Risk
(High Cap Rate)
$28.2 billion $6.6 billion 23%
BB&T (US Bank) More Desirable Low Risk
(Low Cap Rate)
$27.4 billion $2.1 billion 8%

By no means are we saying that location is the sole explanatory factor for the difference in earnings yields between these two banks, but we can safely assume that it plays a very large role in both the market's expected growth rate and level of uncertainty, or risk, associated with future earnings. To see it in more general terms, consider that the earnings yield of the DFA Emerging Markets Portfolio (DFEMX) is currently about 42% higher than the earnings yield of the S&P 500 Index.

It is crucial to remember that more expected return, higher cap rates and higher earnings yields are generally associated with more risk, or in other words, risk and return have a positve correlation. Also, if we limit our discussion to just the buildings or companies in the less desirable neighborhoods, the price will adjust to reflect the risk of the receiving the income in the future. As uncertainties of all the relevant factors change due to new information (just think of this information as random and upredictable news), the random walk of market prices will move inversely proportional to the overall risk so that the buyer can expect a return that is commensurate with the risk of the investment. 

Marlena I. Lee said it perfectly when she wrote that "return generation is the responsibility of the market, which sets prices to compensate investors for the risks they bear."