This is probably the first and most fundamental concept to understand. "Return on Costs" refers to the investors annual return (example 5% per year) on their investment. It changes, and hopefully grows, over time. This concept is applicable to many industries beyond real estate.
"Cap Rate" is a commercial real estate term. It is short for "capitalization rate". Mathematically, it is the "net operating income" (NOI) divided by "price". It is important to understand that NOI changes over time and even price can mean different things.
Jargon: “Going In” or “In Place” Cap Rate
Timing: At acquisition
NOI: Based on existing leases.
Price: Purchase price and/or total costs at acquisition
Jargon: “Mark to Market”
Timing: At acquisition
NOI: Ignore existing leases. Assumes everything is leased at market rent.
Price: Purchase price and/or total costs at acquisition
Jargon: “Return on Costs”
Timing: Upon stabilization at market rent
NOI: Ignore existing leases. Assumes everything is leased at market rent.
Price: Purchase price + future leasing costs + future capital costs incurred once all the initial leases expire and are leased at future market rents.
Data Used for Calculations
In Place NOI: $300,000
You are buying a 50,000 SF property 100% leased to one tenant with 2 years left on the lease (referred to as 2 years of WALT). The in-place rent is $0.50 psf/mo NNN = $25,000 / mo or $300,000 / year. Because the lease is NNN, the NOI is the same as the rent. NOI = $300,000.
Market NOI: $390,000
If the property was vacant, it would lease at $0.65 psf/mo NNN = $32,500 / mo or $390,000 / year.
Purchase Price: $5,000,000
This is what you are paying the seller.
Total Costs at Acquisition: $5,100,000
Additional $100,000 on legal and closing costs.
Total Costs at Stabilization: $5,500,000
Additional $400,000 on future leasing (TI/LC) and cap ex to renew or replace the existing tenant.
Cap Rate Calculations
Going In = $300,000 / $5,000,000 = 6.0% on purchase price
Going In = $300,000 / $5,100,000 = 5.9% on total acquisition cost
Mark to Market = $390,000 / $5,100,000 = 7.6% on total acquisition cost
Return on Costs = $390,000 / $5,500,000 = 7.1% when new lease is put in place at market rent
Discussion
In this example the buyer’s going in cap rate is 5.9% but will grow to 7.1% once the lease “rolls to market”. This shows you how the going in cap rate may not tell the whole story of what the property could be worth, particularly at times when market rents have grown significantly.
Reference Sheet
Download here: Return on Costs
Disclaimer: This information is provided to help you better understand commercial real estate. It is based on my experience over 20+ years. There is no guarantee that this information will allow you to be successful. No guarantee is provided as to the accuracy of the information. It is provided for educational purposes only.