Understanding Cap Rates as a Passive Real Estate Investor

I have a partner in a deal who is a very experienced (and successful) multifamily investor.

It’s natural to assume that given his decades of experience, he uses a highly-refined underwriting spreadsheet to value the deals he looks at.

But he’s just the opposite – he underwrites his deals with a simple, four-function calculator.

There are a lot of lessons that can be pulled out of this. But what I want to focus on today is simplicity of the math in commercial real estate valuation. It’s literally one line of basic arithmetic.

But while the math is simple, it’s also nuanced. Primarily because a core component is the cap rate.

Cap rates took me a while to understand, because the term can be used for three different numbers: the market’s cap rate, a deal’s going-in cap rate, and the exit cap rate the sponsor projects.

As an LP, you’ll never directly set any of them. But every return projection in every deck is built on assumptions that ultimately tie back to cap rates…and one in particular is the easiest place to artificially inflate a deal’s numbers.

What the Number Actually Measures

The basic formula: property value = NOI ÷ cap rate. NOI (net operating income) is what a property earns after operating expenses, but before loan payments.

So a building producing $100K of NOI, in a market trading at an 8% (market) cap rate, is worth $1.25M ($100K ÷ 8%).

Another way to think about the cap rate is that it’s a multiple on earnings – exactly the same as a stock or private business that’s valued on its revenue or net income.

Using the example above, an 8% cap rate translates into a 12.5x income multiple ($100K * 12.5 = $1.25M). At a 4% cap rate, the same $100K of NOI prices at $2.5M (a 25x multiple).

A lower cap rate means the market is paying a higher multiple for the same dollar of income.

The Market’s Cap Rate and Your Deal’s

The market cap rate is set by what comparable buildings trade for and moves mostly with the cost of debt (which in CRE is heavily influenced by the yield on the 10-Year Treasury). It is not directly controlled by me, you, or any deal sponsor.

On the flip side, a deal’s going-in cap rate is its own arithmetic: the current (not projected) NOI divided by purchase price. It will typically be close to the market cap rate, unless there’s major distress.

The market cap rate is essentially fixed (but is subject to argument interpretation), and the going-in cap rate is only influenced by raising or lowering the purchase price (which either lowers or raises the going-in cap, respectively).

To put these two concepts together: the market sets the multiple, and the operator can only influence the NOI and the purchase price.

The Red Flag: Exit Cap Rates

The exit cap rate is a sponsor’s projection of what the market cap rate will be when it comes time to sell.

And because cap rates are THE valuation lever in CRE, the exit cap rate has an outsized influence on projected returns of a deal.

If most of a projected return comes from selling at a lower cap rate than the purchase, it means the sponsor needs the market to pay a richer multiple at some point in the future.

And remember, market cap rates aren’t controllable – so a deal with most of its returns coming from an exit cap rate that is significantly lower than the going-in cap rate is essentially a bet on where interest rates will be at the time of sale.

Our example building doubles in value to $2.5M if cap rates compress to 4%, with no income growth.

Reverse it: buy at the 4% top, and a drift back to 8% leaves the same NOI supporting half the price. Even if the income grows 30%, it’s still worth far less than you paid. Add a typical loan, and the equity in the property is easily wiped out completely (a lot of LPs in 2021-2022 deals are living with that math today).

The exit cap rate is how one cell in a spreadsheet can manufacture a 20% IRR.

The Two Numbers to Put Side by Side

Cap rates sit at the center of CRE valuation – but just like with IRR, no single number tells you whether a deal is good. And specifically for cap rates, the market, going-in, and exit each tell different parts of the story.

So when you’re evaluating your next LP investment, make sure you know all three, and specifically compare the going-in to the exit. If the exit cap rate is more than 1% below the going-in, it’s time to ask the sponsor some hard questions.

Because NOI is the only lever anyone in the deal controls. A deal that works on income alone is an investment in the operator’s plan – but one that needs the multiple to move is a bet on interest rates, no matter how the pitch deck frames it.

If you want to know more about cap rates, Adam and I devoted the very first episode of our No Investor Left Behind podcast series to them.