The capitalization rate, often referred to as the “cap rate,” measures the expected yield on a commercial real estate investment. It is calculated by dividing the property’s net operating income (NOI) by its current market value. Cap rates are often used by investors to compare the potential return on different properties, as well as to determine the potential value of a property based on its NOI.
Cap rate duration in commercial real estate is a measure of how an asset’s market value changes in response to a change in its cap rate. In simple terms, the cap rate is the rate of return that an investor can expect to earn on a property, based on its income and expenses. The cap rate duration, then, is a way of measuring how sensitive an asset’s market value is to changes in its cap rate.
Mathematically, cap rate duration is a modified duration calculation. This means it accounts for the potential impact of changes in the cap rate on the market value of a property, providing a more accurate measure of the property’s sensitivity to changes in the market.
To illustrate how this works, let’s use the example of a multifamily property with an in-place net operating income (NOI) of $250,000 and an initial cap rate of 4.50%. This means that, based on the property’s income and expenses, an investor can expect to earn a return of 4.50% on their investment.
Now, let’s say that the cap rate for this property increases to 5.50%. This means that the property’s market value will change, because the higher cap rate means that the property investors now require a higher rate of return.
To calculate the change in the property’s market value, use the following formula: Market Value = NOI / Cap Rate
In our example, the NOI is $250,000, the initial cap rate is 4.50%. Plugging these numbers into the formula, we get:
Market Value = $250,000 / (0.045 – 0) = $5,555,555
If the cap rate increases to 5.50%, as in our scenario, the market value of the property will change, because the higher cap rate means that the property is now expected to earn a higher rate of return for investors. Using the same formula, we get a value of:
Market Value = $250,000 / (0.055 – 0) = $4,545,454
As you can see, when the cap rate increases from 4.50% to 5.50%, the market value of the property decreases slightly more than $1 million from $5,555,555 to $4,545,454. The cap rate duration of this asset is 18.18%, based on the change in its market value when the cap rate increases from 4.50% to 5.50%. For every 1% increase in the cap rate, the market value of the asset decreases by 18.18%.
In summary, cap rate duration is an important concept in the commercial real estate industry. It measures the sensitivity of a property’s market value to changes in the cap rate. Understanding this concept can help investors make more informed decisions when assessing potential investments in commercial real estate assets such as multifamily properties.