While learning about the relationship between the Cap Rate and NOI, there’s a particular reasoning that was itching me because I could not fully understand it.
So, the formula for the Cap Rate is this one:
$$ Cap \space Rate = \frac{Net \space Operating \space Income \space (NOI)}{Property \space Value} $$The cap rate shows the percentage of the property’s value that is represented by a given year’s NOI. If we rearrange the formula, the Property Value could be inferred in terms of both the Cap Rate and NOI.
$$ Property \space Value = \frac{Net \space Operating \space Income \space (NOI)}{Cap \space Rate} $$So, for a property yielding a fixed amount of NOI per year, say €100,000, the estimated property value is inversely proportional to the cap rate.
| cap rate | property value |
|---|---|
| 4% | €2.50M |
| 5% | €2.00M |
| 6% | €1.67M |
| 7% | €1.43M |
| 8% | €1.25M |
| 10% | €1.00M |
Of course the formula makes sense, but it is the reasoning behind it that I find counterintuitive. It feels natural to think that if I expect a higher cap rate for a property, the value of the property should be higher, no?
This is the wrong framing. The way to see the cap rate variation is to interpret it as getting more income for each euro the buyer invests. If the NOI is fixed, a potential buyer that demands a higher return on their money will be willing to pay less for the property, not more.
Imagine the same property from the table example before, like an appartment building, yielding €100,000 per year. That’s the NOI, that’s fixed. Now, we have three buyers:
| Buyer | Return demanded | Most they’ll pay |
|---|---|---|
| A | 5% | €2,000,000 |
| B | 8% | €1,250,000 |
| C | 10% | €1,000,000 |
Buyer A is content with the money coming from the NOI being only a 5% return against the value of the property, versus buyer C that demands a 10% return on their money for the investment to be attractive, thus the wild difference in property value estimations.
The question is now:
Why would anyone accept a 5% return versus a 10% return?
Why not always chase the highest return and pay the least for the property?
The answer lies in the characteristics of the properties being evaluated. Let’s say you are evaluating two buildings, again both yielding €100,000:
- Building A is in the middle of the city center, there’s barely any tenant turnover and rents are likely to rise.
- Building B is in an office park in the outskirts of a small city. It might stay occupied it might not.
Several people bid for buying the first building until the price reaches €2,000,000. The buyer is content with that eventual 5% cap rate. For the second building, someone pays €1,000,000, meaning they get a 10% cap rate because they are paying for the extra risk.
Have fun!