Why It Matters
Capitalisation Rate
Summary
We have measured the capitalisation rate of the various property types in your area.
Definition
The capitalisation rate (commonly known as the “cap rate”) of a property represents the percentage return a property investor would receive if a property was purchased for cash today. When simplified it can be thought of as a property’s yield based on today’s value. The cap rate we calculate is therefore exclusive of any allowances made to accommodate the cost of capital (i.e. debt interest or equity cost). It is calculated as the Net Operating Income, (or NOI) divided by the property’s current value. So, for example, if a property is presently worth £1,000,000 and had an NOI of £100,000, then the cap rate would be (£100,000/£1,000,000), which is 0.1 or 10%.
Interpretation
DETACHED
| Dataset | Explanation |
|---|---|
| Lower Capitalisation Rate for Detached House Type | This is an estimation of the Capitalisation Rate based on the Lower Annual Rental Price for Detached House Type Across Postal Sector. |
| Upper Capitalisation Rate for Detached House Type | This is an estimation of the Capitalisation Rate based on the Upper Annual Rental Price for Detached House Type Across Postal Sector. |
FLATS/APARTMENTS
| Dataset | Explanation |
|---|---|
| Lower Capitalisation Rate for Flat House Type | This is an estimation of the Capitalisation Rate based on the Lower Annual Rental Price for Flat House Type Across Postal Sector. |
| Upper Capitalisation Rate for Flat House Type | This is an estimation of the Capitalisation Rate based on the Upper Annual Rental Price for Flat House Type Across Postal Sector. |
SEMI-DETACHED
| Dataset | Explanation |
|---|---|
| Lower Capitalisation Rate for Semi-Detached House Type | This is an estimation of the Capitalisation Rate based on the Lower Annual Rental Price for Semi-Detached House Type Across Postal Sector. |
| Upper Capitalisation Rate for Semi-Detached House Type | This is an estimation of the Capitalisation Rate based on the Upper Annual Rental Price for Semi-Detached House Type Across Postal Sector. |
TERRACE
| Dataset | Explanation |
|---|---|
| Lower Capitalisation Rate for Terrace House Type | This is an estimation of the Capitalisation Rate based on the Lower Annual Rental Price for Terrace House Type Across Postal Sector. |
| Upper Capitalisation Rate for Terrace House Type | This is an estimation of the Capitalisation Rate based on the Upper Annual Rental Price for Terrace House Type Across Postal Sector. |
Why the metric matters
Understanding yields, capitalisation rates and payback periods are important aspects of being able to weigh up the value of a property so as to try and form a judgement as to whether the price represents good value or not. Before however we dive into what to what the yields, capitalisation rates and payback periods data can inform us on it is worth going back to basics on why the measures exist.
If we (perhaps overly) simplify things, in urban areas, there are three main approaches to valuing real estate. Where a property is valued primarily for residential purposes, the “sales comparison” method is generally regarded as the most valid indicator of likely market value. Although some principles from the sales comparison method are borrowed in the other two valuation methods (named below), what makes it unique is that it does not explicitly tie the value of a property to any form of income that a property can generate. Rather, the underlying premise of the sales comparison is that the market value of real estate is related to the prices of comparable, (i.e. largely substitutable ) properties. The sales comparison method uses sales/transfer prices paid, as indicators, of a property’s market value.
The legitimacy of the sales comparison method is based on four largely uncontested constants in classical economics, namely: (1) utility; (2) supply; (3) demand; and (4) substitution. Utility theory provides that value is dependent on a bundle of utility-forming characteristics associated with each property, such as its location, condition and size. The price which people are willing to pay for such characteristics, determine its value to market participants (i.e. potential buyers in London). Utility value is subsequently increased or diminished by the effects of supply (i.e. sellers) and demand (i.e. purchasers), inclusive of macroeconomic supply side stimuli (i.e. development tax breaks) and macroeconomic demand side stimuli (i.e. Help to Buy). Substitution theory comes in because if the utility value as mediated by supply and demand greatly differs from the price needed to acquire a substitute property of similar utility and desirability, within a reasonable amount of time, then the property is over or under priced for a reason that cannot be attributed to market forces, such as is the case when property is gifted under value to a family member. Provided therefore substitute properties are available the price of property when valued in accordance with the sales comparison method should simply be the utility value as mediated by supply and demand.
Where a property is used for investment purposes, i.e. it can generate an income stream, one of two investment valuation methods are applied. The first “P/E” approach is essentially a property price to income ratio obtained by applying a yield or capitalisation rate to the current income stream (i.e. the rent being paid by a tenant currently). The most basic versions of this approach include no explicit assumptions regarding future income stream changes (such as those that may occur when a “rent review” is undertaken ). The yield or capitalisation rate is derived from the analysis of similar transactions to determine the income stream or property price. The second “DCF” approach is to estimate the present value of the future sale price and income stream, by discounting the income and future sale value at an appropriate discount rate. The method requires assessments of future rental incomes and property prices as well as the level of compensation required to make the risk of investing in property “worth it”.
In estimating the separate income/rent and property price components needed to value investment property, investment valuations depend on two distinct markets. The market for space which determines the price tenants and occupiers will pay for to use a property (as influenced by utility value, supply demand and substitution), and the market for capital which determines the terms on which debt or equity or debt capital will be provided must be sufficiently competitive and provide a clear pattern of rents and interest rates, respectively. These markets must therefore be at equilibrium. As the yield and/or cap rate is a ratio that relates net income (i.e. rent) to sale prices, with both rents prices are established in distinct markets, yields and/or cap rates require both rents and prices to be independent but within a sympathetic distance of one another to allow a level of equilibrium and permit investment properties to be bought and sold and leased or occupied at prices tenants can afford.
This is, in essence, what yields and/or cap rates represent, and where they derive their utility in pricing or valuation practice. So long as sellers aim to secure the highest price for the property and therefore sell at the lowest cap rate possible, and buyers aim to purchase the property at the lowest price possible, being equal to the lowest cap rate possible, yields and/or cap rates would not be expected to change in real terms without intervening forces that alter the ratio between market rents and market prices. Some of the intervening forces are tabulated below.
| Scenario | Intervening Causal Forces |
|---|---|
| Original Purchase Price / Current Rent, Yield Increase | The price which tenants and occupiers are willing/must pay for space is increasing. This is likely to be the result of: • Micro/macroeconomic, spatial or legal factors which have increased tenant’s revenues from which rent is apportioned, limit the supply of substitutable space or induced its demand. • Improvements in the quality of the tenant’s space that justify a concordant rental price increase. |
| Original Purchase Price / Current Rent, Yield Decrease | The price which tenants and occupiers are willing/must pay for space is decreasing This is likely to be the result of: • Micro/macroeconomic, spatial or legal factors which have decreased tenant’s revenues from which rent is apportioned, induced an oversupply of substitutable space or weakened its demand. • Improvements in the quality of the tenant’s space that justify a concordant rental price increase. |
| Current Purchase Price / Current Rent Cap Increase | • An increase in the investable risk-free interest rate of asset risk premium would increase the cap rate as the return investors would expect from capital outlays would increase • Actual rental / NOI increases (or vacancy rate equilibrium is lost), without and equilibrium increase in the property price (i.e. cost of capital is above equilibrium) would increase the cap rate • Predicted rental / NOI decreases would increase the rent cap rate |
| Current Purchase Price / Current Rent Cap Rate Decrease | • A decrease in the investable risk-free interest rate or asset risk premium would decrease the cap rate as the return investors would expect from capital outlays would decrease • Actual rental / NOI decreases (or vacancy rate equilibrium is lost), without an equilibrium increase in the property price (i.e. cost of capital is above equilibrium) would decrease the cap rate • Predict rental / NOI increases would increase the cap rate |
Image: Centre For Cities