All you need to know about cap rates

The words ‘capitalisation rate’ or ‘cap rate’ have been flying around the property trust sector recently, as trusts explain away the large writedowns on their property portfolios. But rarely does anyone stop to explain the term for the benefit of outsiders. If you’re confused by it, then you’re not alone. We’ve had a number of queries to our Ask the Experts forum, like this one from Alan S: ‘Are you able to point me to an Investor College article and or quickly summarise the issue of “cap rates” please.’ Well, this, as you’ll have guessed, is that Investor’s College.

Simple meaning

The good news is that the meaning itself is very simple. ‘Capitalisation rate’ derives from the verb ‘to capitalise’, which can be used to describe the process of going from the ongoing income or cost of an asset or liability to its capital value. So a capitalisation rate is simply the rate at which you do that.

If you have an income of $10 a year and you decide to estimate its capital value based on a capitalisation rate of 10%, then you’d have a value of $100 ($10 divided by 10%, or 0.10); if you used a cap rate of 5%, then you’d get $200 ($10 divided by 0.05); and if you used 20%, you’d get $50 ($10 divided by 0.2).

It’s like the dividend yield on shares, or the rental yield on property. It’s just that it tends to get called a yield when you apply it to the value (or more likely the price) of something to see what income you’ll get, and (at least with property) it’s often called a cap rate when it’s applied to the income from an asset to see what its value (or more likely its price) might be. So the cap rate is basically nothing more than an assumed rental yield you use to calculate the value of a property.

Cap rates in theory

So far so good. The real problems are hidden in that word ‘assumed’. What rental yield (that is, what cap rate) should you assume for your calculations? This takes us back to the basic valuation fundamentals we looked at in our Investor’s College article of issue 198, How to value stocks and shares, and which are covered more fully in our book Value: The Intelligent Investor’s Guide to Finding Hidden Gems in the Sharemarket.

But, to summarise here, you’ll want a total return from an investment that at least matches the returns you can get elsewhere (your ‘opportunity cost’), and your total return is made up of your yield from an investment, plus the growth you anticipate in that yield. The opportunity cost is normally thought of as the yield on long-term government bonds (the safest investment) plus a premium to account for the additional risk of other investments.

Putting all that together, you get the formula: Long-term government bond yield Risk premium = Rental yield Anticipated rental growth. And, turning that around, you get: Rental yield (that is, Cap rate) = Long-term government bond yield Risk premium – Anticipated rental growth.

Right now we’re in a curious situation, because the long-term government bond yield has been shooting down (you can see the rates on the Bloomberg website), while risk premiums have been shooting up as investors have lost their appetite for risky assets. Meanwhile, anticipated long-term rental growth may have edged down a little, in response to fears of a long recession. All in all, you’d certainly expect cap rates to edge up a little.

Cap rates in practice

What actually seems to be happening is that cap rates are edging up a lot (as you can see in the chart), and they look set to edge up a fair bit more before we’re through. Property valuers (or pricers more like), you see, don’t like imponderables like risk premiums and long-term rental growth and prefer to use hard evidence from transactions actually taking place. So instead of working out an appropriate cap rate from first principles, they tend to look at those implied by recent property sales.

At first glance that seems sensible enough, but the trouble is that it introduces a degree of circularity to the calculations. Instead of assessing the value of a property according to fundamental external factors, you’ve switched to basing your property valuations on the valuations of other properties, and that, bluntly, is how we get bubbles.

As prices move higher, cap rates move lower and property owners get to revalue their properties higher again. Hey presto the bank will lend them more money, so they can pay more for more properties and the price moves higher and so on. When the bubble eventually bursts, then the prices tumble, the cap rates rise, writedowns follow, the banks withdraw credit and prices fall further.

None of this may matter to a conservative property investor – after all, if you don’t like the price you don’t have to sell. But unfortunately a lot of property trusts have been far from conservative and they’ve covenanted to their lenders that their property values will stay above a certain level. So when auditors (or perhaps valuers appointed by the lenders themselves) force them to write down the assets, covenants may be breached, thereby giving the lenders certain (in some instances draconian) rights under the loan documentation.

As Nathan Bell wrote last week in Cap rate carnage, there could be much more pain to come for property trusts. Just don’t be fooled into thinking that cap rates, as used in practice, have anything to do with property values. In fact they’re all to do with the price, but that’s what the bankers seem to care about and they generally have the loan documentation behind them.