Going-In Cap Rate

 

What is a Going-in Cap Rate?

The going-in cap rate is an important calculation that measures the ratio of net operating income (“NOI”) to purchase price for your asset. There are two different ways to determine the going-in cap rate depending on the type of project (Acquisition vs. Development).

For an acquisition, the going-in cap rate is defined as the forward twelve NOI divided by the purchase price of the property. The forward twelve NOI is defined as the sum of the upcoming twelve months from the acquisition. Some firms opt to annualize the NOI and might instead take a forward three month or even a one-month NOI and annualize by multiplying by a factor to get the implied NOI for the entire year. The purchase price is the price before the addition of closing costs.

Going in Cap Rate Equation

For a development, the going-in cap rate is sometimes called a stabilized cap rate and is the forward stabilized NOI divided by the total project cost. For example, the forward stabilized NOI in a multifamily development project would begin when all of the units are leased, and the project has reached one hundred percent occupancy. From that point, one would take the forward twelve NOI or annualize to derive an annual NOI amount. The total project cost would include the land purchase price, hard and soft costs, and any sort of financing fees as well as construction debt interest.

Going in Cap Rate Equation

For example, if a project forecasts that it will receive $100,000 of forward stabilized NOI and the total project cost is $2,000,000 the going-in cap rate or stabilized cap rate would be 5%.

Going in Cap Rate Equation

The difference between the two formulas for acquisition and development going-in cap rate is due to how the properties are initially leased.  The going-in cap rate for an existing property is determined by the already pre-existing cash flows, whereas in a development, the buyer is creating a cash flow that did not previously exist.

Why is the Going-In Cap Rate important?

The going-in cap rate is significant because it helps investors assess real estate based on a project’s current value and net operating income. Typically, real estate investments trade at cap rates between 5 and 10 percent depending on geography, property type, and many other factors. Investors usually do not enjoy seeing what is called “cap rate compression”.  Cap rate compression is the comparison between the going-in cap rate and the exit cap rate.  If the exit cap rate is lower than the going-in cap rate, this is referred to as cap rate compression.  Basically, this is implying that the property, assuming no change to NOI, will be valued higher at the exit just based on a lower cap rate. If your investment assumes cap rate compression, it will be viewed as riskier and will sometimes downplay the value you are creating through the operations of the investment.

How could the Going-in Cap Rate be misleading?

For an acquisition, the going-in cap rate could be misleading for a number of reasons.  First, there could be vacancy in the asset which understates the NOI, or conversely, tenants that are about to vacate.  Second, there could be free rent that understates the NOI.  Third, higher going-in cap rates do not always mean a good investment because it could be a riskier asset or be subject to a lease that is expiring soon.

Conclusion

The going-in cap rate is important because it provides insight into how risky an investment is compared to other opportunities. It is important to note the different formulas for developments and acquisitions and be mindful of using the proper formula for a project.   Going-in cap rates are also important to determine if there is cap rate compression but be cautious to not just rely on the going-in cap rate to analyze a potential investment.


 

About the Author

Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions on going-in cap rates or if he can help you with your modeling needs.

 
Eric Bergin