When evaluating a real estate investment, the cap rate, or ratio of annual net income to invested capital, dictates how long it will take to recoup your initial investment. The lower the cap rate, the longer it will take. Such a calculation functions a little differently when discussing REITs, and investors should instead look to the Implied Cap Rate. The implied cap rate is calculated by dividing the REIT’s net operating income by its market cap.
Q. This is a critical metric in evaluating REITs, but it seems like we should review “cap rate” before getting to “implied cap rate”…
A Yes. In RE, “cap rate” tells you how long it will take to recover your investment. So, imagine a building costs you $10mm and generates rents of $4mm/year. Now lets say that the fixed and variable costs of the building run something like $3mm/year. Your net income is $1mm, so your cap rate is $1mm/$10mm, or 10%. It’ll take 10 years to recover your investment. With a cap rate of 5%, it’ll take you 20 years. The higher the cap rate, the faster you get your money back.
Q. And developers and investors use cap rates all the time when looking at private real estate transactions. But how does it work with a REIT?
A. Same sort of general idea. You take the net operating income of the REIT — that is, the REIT’s income, and divide it by the market cap, because the market cap is essentially what you’re paying to acquire the properties inside the REIT. The market cap is substituted for the property acquisition costs. Of course, REITS have to pass through most of their income back to the investors, so it’s not a horrible comparison to the normal cap rate calculation.
Q. So, of course, you can compare one REIT to another with this metric…
A. Yes, and you can also do something that’s normally very difficult. If you consider a REIT that has, say, mostly apartment buildings and you look at its implied cap rate, you can compare that to a private apartment deal and essentially see how much you’re paying for the convenience of going through the REIT. So you can compare your “DIY” option to the alternative of just buying a public security. That’s pretty unusual.
Q. So when you calculate the implied cap rate, are there any major tricks?
A. The biggest one is making sure you’re looking at forward NOI. The big thing to net out is depreciation, and you have to ensure you’re looking forward because the market cap of the REIT obviously is discounting that, not the actual costs of the buildings.
Q. And in both cases, implied and actual, high cap rates are good…
A. The big thing to remember about cap rates: higher is better, because it means you’ll get your money back sooner.