The Cap Rate Series: The Answer Is No Longer 9%

Author’s note: Brad Thomas is a Wall Street writer, and that means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free, and the sole reasons for writing it is to assist with research and provide a forum for second-level thinking.

A cap rate – which is short for capitalization rate – is the answer you get when you divide a rental property’s net operating income by its all-inclusive purchase price.

Over the next few weeks, we plan to launch a new series called “Cap Rates in Action,” in which we will highlight most major property sectors.

As you will discover throughout my cap rate series, the average cap rate across all property sectors is no longer 9%.

Real estate is a business. Big business, in fact.

That’s why real estate investment trusts, or REITs, exist in the first place. Because people will pay to use someone else’s land.

They’ll pay to live there, as in the case with residential REITs of the apartment, student housing, manufactured home, and single-family home variety.

They’ll pay to do business there, as with office REITs.

They’ll pay to do commerce there, as with retail REITs, from freestanding buildings to malls, to shopping centers, to shopping outlets.

For that matter, they’ll pay to:

That’s a sizable list of moneymaking opportunities right there, but the list hardly ends with them. There’s also timberland REITs, infrastructure REITs, data center REITs, and specialty REITs.

And every single one of them can make some serious money. Under the right circumstances and with the right guidance, of course.

Now, by law, REITs of any shape, size, or focus are designed to not only make “some serious money” for their owners and operators. They’re also structured so that the investors who in many ways fund these impressive, expansive, property-based undertakings make a tidy sum as well in the form of dividend payouts.

To be sure, most REITs do indeed live up to those promises and potential.

But just because most REITs are solid and safe business opportunities doesn’t mean all of them are. Please don’t fall into the oh-so-easy trap of thinking otherwise.

I’m a huge proponent of this kind of investment opportunity. My daily articles on Seeking Alpha and other credible financial sites; my speaking engagements on TV and around the country; and my book, The Intelligent REIT Investor, prove as much. These companies are great sources of additional yearly income or money to set aside for retirement.

However, I never, ever, ever go into a real estate investment trust blind.

Instead, I look into the details of what each one does. I analyze managements’ movements. And I calculate the cap rate… a simplistic yet invaluable tool that can tell me – and you – a lot about how safe or risky a REIT’s forward-thinking potential really is.

This might very well be the most important calculation you make in deciding which REITs to bank on.

That and which ones aren’t worth your time.

A cap rate – which is short for capitalization rate – is the answer you get when you divide a rental property’s net operating income by its all-inclusive, bottom-line purchase price. As I explained in a Forbes article many moons ago (i.e., April 22, 2015):

There are many ways to value real estate, broadly speaking, and that consists of appraising the land and building, comparing comparable properties, [and] calculating the value based on the rents being generated.

The latter method is where cap rates come into play. By examining the actual income (or rent) that the property generates and then deducting operating expenses (not including debt costs), the investor arrives at a property-level net operating income, or NOI. Once you determine the NOI, you simply divide that by the cost of the property…

Net Operating Income ÷ Current Market Value of the Asset = Cap Rate

Now, net operating income may or may not be listed in black and white in a REIT’s profile on your investment data platform of choice. So here’s how to calculate that as well:

Gross Operating Income – Operating Expenses = Net Operating Income

I’m not saying that this is all you need to know. Again, I look at plenty more information than this.

But I am saying that the results of these calculations could tip my professional opinion from nay to yay… or the opposite way around.

In the first edition, we will explore net lease REITs, such as Realty Income (O), National Retail Properties (NNN), Vereit (VER), Store Capital (STOR), and Global Net Lease (GNL).

Then we’ll move on to healthcare REITs, with coverage of the medical office building REITs such as Healthcare Trust of America (HTA) and Physicians Realty (DOC), skilled nursing REITs like Omega Healthcare (OHI) and Sabra (SBRA), and diversified REITs like Ventas (VTR) and Welltower (WELL).

I recall reading an article over two decades ago that was written by a Harvard professor named Bob Ellis.* He taught MBA students about real estate capital markets and, in the article, he explained how he would always begin his first day of lecturing by asking students the following question:

Knowing full well that his question would pique their curiosity, he continued with another attention-grabbing line:

The answer to the final exam will be nine.

This would begin his series on real estate in general and the subject of “cap rates” in particular. As he’d explain to them, his plan was to lecture on various real estate asset classes (e.g., hotels, office buildings, etc.). And, when he was finished, he would give a final exam in which he would ask the students:

This brings us back to his statement about “nine.” Strange as it might seem for a Harvard professor to give away an answer to a final exam, Ellis was prompting students to truly contemplate and actually grasp the concept of cap rates.

That was true then. But times have a’changed…

As you’ll discover throughout my cap rate series, the average cap rate across all property sectors is no longer 9%. It will be interesting to discover the new norm (i.e., the average cap rate across all property sectors) and, perhaps – thanks in large part to the influence of REITs and their low cost of capital – the new answer to Professor Ellis’ thesis will be closer to seven.

In our cap rate series, we’ll also offer investment spread insights into the profit margins between cost of capital and model profit in order to highlight the REITs with the best, most sustainable growth profiles.

In short, get ready for the next series… It’s going to be a good one!