The going-in cap rate or capitalization rate, or initial yield, as is often referred to, is calculated as the ratio of the projected net operating income (NOI) in the first year of the holding period over the acquisition price of the property. This measure also represents the investor’s income return in the first year, but also in subsequent years if NOI remains stable.
Some authors and analysts, when referring to the cap rate calculation, refer to the use of a stabilized NOI instead of a first-year NOI. There may be a discrepancy between the two if the property has a high vacancy rate at the time of acquisition. Stabilized NOI refers mainly to the income that the property can produce at a long-term average occupancy in the market within which it competes for tenants. This may range from 90% to 95% depending on property type and location. However, a 95% occupancy is more often used for the calculation of stabilized NOI.
An investor considering acquisition of an income-producing property can calculate the going-in cap rate implied by the seller’s asking price as a quick way of evaluating the reasonableness of the asking price. For example, an asking price of £10 million for an office property with projected first-year NOI of £300,000, which implies a going-in cap rate of 3% is unreasonably high. Going-in cap rates for commercial property rarely fall below 6%, especially in the case of office property, so a 3% signals a very high price.
The major question for a property investor contemplating an acquisition is the maximum price he/she can pay in order to achieve a minimum target return. This price will also determine the minimum going-in cap rate the investor will accept in acquiring the property.
The minimum price an investor can pay for a property in order to achieve a minimum internal rate of return (IRR) over a projected holding period should be calculated using the discounted cash flow model. This model takes into account all acquisition costs, expenses (including loan repayments) and revenues during the holding period, as well as the resale price and the remaining balance of any mortgage loan associated with the proeprty at the end of the holding period.
In cases that the investor is interested mostly in securing a minimum income return, with little concern about appreciation, then the minimum acquisition price maybe determined by using his/her required minimum income return as the going-in capitalization rate. However, this minimum required income return needs to be adjusted accordingly if the stability of property income is not secured through long-term leases, and if the risk of property value declines is high.
Of course, it is important to understand that independently of the investor’s required return, a typical prorerty transaction (where no special circumstances are present that will force the seller to sell below market price) property will take place only at a price that will reflect a going-in capitalization rate that is in line with market prevailing cap rates for the particular property type in the local market. Such market cap rates can be estimated using data from recent sales of comparable properties in the local market. The methodologies for estimating going-in cap rates are discussed here.
Investing for Double-Digit Returns
When investing for double-digit returns the following considerations should be taken into account in relation to the going in capitalization rate:
– It is important to achieve a reasonably high income return over the holding period so that less appreciation (increase in value) will be needed to achieve a total return in the double digits (10%+). Thus, the going-in cap rate should be such that it allows at least a 7% income return not only in the first year of the holding period but also over the entire holding period. If there is reasonable risk of a decrease in future rental income, and therefore NOI, then the investor needs to achieve a higher going in cap rate, increased by the estimated annual percentage decrease in NOI relative to value. As indicated earlier, the investor actually will need to enter the projected rental income and NOI in a discounted cash flow model and discount the after-tax cash flows of the property using the required total return (not the required income return) in order to estimate the present value of the property’s cash flows. The so estimated value will provide the price, which will still give the investor the required double-digit return, given the projected rent declines and their impact on value.
Similarly, in markets in which prices are declining, as opposed to rising, the going-in cap rate should be such that even with negative change in value would allow double-digit returns. Again, discounted cash flow analysis that will take into account that the resale price will be lower than prevailing market prices at the time of acquisition, will provide the appropriate acquisition price and the implied going in capitalization rate that will allow the investor to achieve the minimum required return under the projected value scenario