New on FinoLib · Volume III: Finance Encyclopedia
New on FinoLib, my finance education website: I have published an article called Cap Rate Explained: Property Valuation and REITs, from Volume III: Finance Encyclopedia. Here is what the article explains, written as a short expert briefing; the full piece, with every worked example, is one click away.
2.2 Cap Rates and Property Valuation
The idea in plain words
A cap rate is a property’s yearly net income divided by its value, so value equals income divided by the cap rate. It works like a yield. The cap rate equals the required return minus the growth rate of income. So when interest rates rise, cap rates tend to rise too, and property values fall, even though the rent hasn’t changed.
Key points
■NOI is rent after vacancy and operating costs, before debt service, depreciation and income tax.
■At a 6.5% cap rate, a one-point rise in the cap rate cuts value by 13.3%.
■Rents that grow with inflation cushion a rate rise; tightening credit makes it worse (−3.7% vs −23.5% in the scenarios).
A closer look
Commercial real estate’s standard valuation shorthand is the capitalization rate (cap rate) — a property’s annual net operating income (NOI, rental income minus operating expenses, before financing costs) divided by its value. Rearranged, a property’s value equals its NOI divided by the market’s prevailing cap rate for similar properties — directly analogous to the comparable company multiples from Capital Markets Part 1, but applied to buildings instead of companies.
Decision rule
Derive every cap rate twice, from comparable sales and as r − g. If the two differ by more than about half a point, find out why before relying on either. Underwrite the exit at or above the entry cap rate unless you can name the change in r or g that justifies a lower one. These are heuristics. For properties without stable NOI (lease-up, redevelopment), skip the cap rate and build an explicit DCF.
The costliest mistake
Buying at a cap rate compressed by low interest rates and assuming you will sell at the same rate. Buy the $8.00M-NOI building at 5.5% ($145.5M) and sell at 7.0% with NOI unchanged: $8.00M ÷ 0.07 = $114.3M, a $31.2M (21.4%) loss without losing a tenant. With a $101.8M loan (70%) outstanding, equity falls from $43.6M to $12.5M (−71%). Stress the exit cap rate at least one point above entry.
2.3 REITs — Real Estate as a Public Market Asset
The idea in plain words
A REIT is a company that owns income-producing property and lets you buy a slice of it like a stock. It avoids US corporate tax by deducting the dividends it pays, as long as it distributes at least 90% of its taxable income and meets asset, income and ownership tests. Investors judge REITs on funds from operations, adjusted FFO and net asset value rather than on earnings.
Key points
■FFO adds real estate depreciation back to net income and removes gains on property sales (Nareit definition).
■AFFO also subtracts recurring capital spending and has no standard definition.
■The §199A deduction, made permanent in 2025, cuts the top federal rate on ordinary REIT dividends to 29.6%.
A closer look
A Real Estate Investment Trust (REIT) is a company that owns, and typically operates, income-producing real estate, with its shares traded on a public stock exchange — letting ordinary investors gain exposure to commercial real estate without directly buying and managing a building themselves. In most jurisdictions, REITs receive a specific tax advantage (avoiding corporate-level tax) in exchange for a strict requirement to distribute the great majority of their taxable income — typically 90% or more — to shareholders as dividends every year.
Decision rule
Value an equity REIT on price ÷ AFFO and on price versus the net asset value (NAV) of its properties at current cap rates, not on dividend yield. If the dividend exceeds AFFO for more than a year, it is funded by borrowing or asset sales; treat it as at risk. This is a heuristic. For mortgage REITs, which hold loans, ignore FFO and use book value and net interest income.
The costliest mistake
Valuing a REIT on price ÷ earnings. In the example, earnings are $1.20 a share, so the REIT looks expensive at 33.3× while it trades at 14.8× FFO, because $1.80 a share of depreciation is a non-cash charge on buildings that often hold their value. The reverse error, treating FFO as free cash, ignores $0.50 a share of recurring capital spending. Use AFFO for cash and FFO for comparisons.
What the full article covers
In the full article I take you through these sections:
■2.2 Cap Rates and Property Valuation
■2.3 REITs — Real Estate as a Public Market Asset
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Cap Rate Explained: Property Valuation and REITs, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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