After completing a recent CCIM course – one of the many take aways I received was the statement – Cap Rate is NOT Yield.
As an apartment broker in San Diego – someone who lists apartment buildings and rental properties for sale – how could I believe this statement. “Of course Cap rate is Yield”, I thought to myself. Everything we base our evaluations on is the idea that the cap rate you purchase investment property at is going to give you a return on your investment if you pay cash. For example, if the cap rate at the time you buy your investment property is 5% – and you pay all cash, no investment financing – you will get a 5% return (yield) on your investment.
So let’s look at the definition of both cap rate and yield from the website Invesopedia.
Capitalization Rate – often referred to as the “cap rate”, is a fundamental concept used in the world of commercial real estate. It is the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor’s potential return on his or her investment. Invesotpedia
Yield – the income return on an investment, such as the interest or dividends received from holding a particular security. The yield is usually expressed as an annual percentage rate based on the investment’s cost, current market value or face value. Yields may be considered known or anticipated depending on the security in question as certain securities may experience fluctuations in value. Invesopedia
After reviewing the above definitions from Investopedia.com, my questions still go unanswered. In both definitions it clearly states that both cap rate and yield are considered rate of return. So then what was my CCIM instructor trying to prove with his constant driving of the point that cap rate is not yield.
It wasn’t until I went into the CI101 handbook itself that this concept became clear. The example they use is very clear. Cut and paste straight from the text book:
“Suppose an investor acquires a property at a 6 percent cap with the expectation of a 7.5 percent yield. To meet the yield requirement the property will either need to grow in value, increase in NOI, or both. The larger the spread between the acquisition cap rate and the required yield, the greater the required growth in value or increase in NOI. This is analogous to investors being willing to purchase a growth stock at a higher price-earnings (PE) ratio compared to stocks that are not expected to have as much earnings growth. A stock’s PE ratio is the ratio of the price to earnings expected for the stock over the first year of ownership. In real estate the tradition is to take the ratio of earnings to price rather than price to earnings. So a lower cap rate suggests a property that is projected to have more NOI growth.”
In essence – cap rate is not the same as yield because cap rate is more focused on the investment property’s first year net operating income (NOI), whereas yield is focused on the investments rate of return of over time. Like my CCIM instructor put it – Cap Rate is a picture in time, but yield is the entire movie. In that sense, cap rate is more a focus of value at the time of purchase, which is exactly what we – as apartment brokers – use it for.
Everyone you meet in the apartment industry has a different philosophy on how to measure the rate of return you’ll receive from your investment property. At the end of the day, it’s important the you due your due diligence, engage an honest, experienced expert, and don’t take any statements of returns at face value. That way, your next investment purchase will be a successful one.
Doug Taber works with investors who buy and sell apartment buildings and 2-4 unit rental properties in San Diego County, California. Learn more about the San Diego apartment market at www.YourApartmentBroker.com.