By JT Dhoot

The term cap rate or multiple (or some variation thereof) will sound familiar to anyone who’s tried to value a commercial property or a private business. Stakeholders such as investors, brokers, lenders and appraisers often use these seemingly simple metrics to calculate the market value of an asset. Here are five things you need to know about cap rates and multiples.

1. A cap rate is the inverse of a multiple, meaning a 10 per cent cap rate is equivalent to a 10.0x multiple just as a 5 per cent cap rate is equivalent to a 20.0x multiple.

The chart below illustrates this relationship.

The annual cash flow (or some other measure of economic benefit) of an asset can be divided by a cap rate or multiplied by its equivalent multiple. The resulting value will be the same, as shown below.

Value = Annual Cash Flow / Cap Rate = $50,000 / 5.0% = $1,000,000

Value = Annual Cash Flow x Multiple = $50,000 x 20 = $1,000,000

2. Cap rates and multiples are used to convert a single period of economic benefit into value.

The “economic benefit” is typically expressed as an annual amount and although cash flow is preferred, practitioners can also use other metrics such as revenue, earnings before interest and tax (EBIT); earnings before interest, tax, depreciation and amortization (EBITDA); and/or net operating income (NOI), to name a few. In the end, how the cash flow is calculated determines the characteristics of the resulting value (enterprise value, equity value, terminal value). In other words, capitalizing (dividing) or multiplying the annual cash flow of an asset will produce an estimate of value but understanding how that cash flow estimate was derived (before debt vs. after debt, before tax vs. after tax, Year 1 vs. Year 5, TTM actual vs. normalized pro forma) is of critical importance. The cap rate (or multiple) is inseparably linked to the economic benefit to which it is applied, meaning that estimating one in isolation of the other can result in a misleading estimate of value.

3. Cap rates and multiples assume the economic benefit will continue in perpetuity.

Using our earlier example, purchasing an asset for $1,000,000 at a 5 per cent cap rate implies the purchaser will receive $50,000 in the current year and all future years – or does it? Implicit in the cap rate (or multiple) is a growth rate, meaning the investor would expect the $50,000 to grow at a constant rate of x per cent in perpetuity. This is similar to the valuation of a stock using the Gordon Growth Model, also known as the Dividend Growth Model.

4. Cap rates and multiples reflect the perceived risks associated with the underlying cash flow.

All else equal, greater perceived risk means a higher cap rate (lower multiple), which ultimately results in a lower valuation. Let’s look at two potential investment opportunities:

Should you apply the same cap rate (or multiple) to Investment A as Investment B? No, although each investment generates $50,000 in cash flow.  Investment B has more risk even though it has similar growth prospects. In other words, a prudent investor would choose the less risky option (Investment A) over the riskier option (Investment B) if the investor was paying the same price in either situation. Alternatively, the investor would pay less for the risker option (Investment B) by using a higher cap rate in his/her valuation.

5. Cap rates (and multiples) do not distinguish between return of capital and return on capital.

Assuming the cap rate used in the acquisition of an asset will equal the investors return on investment is almost always incorrect (more on this in another article). In real life, cash flows and values rarely increase at a constant rate, investors use varying degrees of financial leverage (debt), and taxes can have a material impact on how much cash the investor is left with in his or her pocket at the end of the day.

Summary

Cap rates and multiples are easy to use but as they say, “The devil is in the details”. While some investors focus solely on the cap rate (or multiple) when evaluating investment opportunities, sophisticated investors understand these metrics are only a starting point. Is purchasing a property at a 5 per cent cap rate or acquiring a business at a 4.0x multiple a good deal? As with most things in life, it depends.

2 COMMENTS

  1. Thanks for your comments Carolyne, I’m glad you found the article informative!

    Great question/comment on costs. As Warren Buffett would say, “Price is what you pay, value is what you get”. This is the approach we take with every engagement as our goal is to maximize value for our clients, which isn’t necessarily the same as minimizing costs. For example, we could prepare an independent appraisal report that just barely satisfies professional reporting standards but if this report fails to address the complexities of the property being valued (and the needs of the stakeholders relying on the report), then what’s the value of this report to the client? Nil. For this reason, we take the time to understand what is being valued and for what purpose, from there we can come up with the most effective cost structure for the client, whether that be a fixed-fee or hourly fee arrangement.

    My colleagues in Toronto help with both commercial property appraisals and business valuations so depending on what the client needs we can coordinate one or more valuation professionals to complete the engagement. Feel free to contact me directly at [email protected] if you have any other questions or comments.

  2. JT

    This article is one of the best written ones to have appeared on REM. I hope readers have taken time to read it thoroughly even if they only are involved with the buying and selling of residential properties.

    In 1990, with ten years in the industry behind me, I took my broker courses, My final choice of remaining courses was to elect between rural properties and commercial properties courses. I chose the commercial course. Not because I intended to be involved with helping people buy or sell commercial properties, but as a general business learning curve. The reason, I pondered, was because many of my residential clients were either business owners and or executives in the business world.

    I wanted to be cognizant about things they might allude to in conversation while doing business with me, and also contemplating whether or not to endeavour opening my own boutique agency, I found the information course valuable. I was surprised to discover it was the most intense of all the courses and no descriptors had adequately described it at all. And it was impacted by all the prior course materials.

    How fortunate for me it was last on the list of my courses. It was the most comprehensive and interesting and I made my highest mark on that course. I was most pleased at then nearly age fifty, to have found the course most interesting as well as productive.

    I mention this because if anyone is considering taking their broker courses, they likely would find it most expedient and helpful to have taken all their other courses first.

    For me it was purely happenstance due to where the courses were located and when because I fit them all into one year while maintaining my regular sales activity. Looking back more than twenty-five years, I truly don’t know how I did it all.

    But surely do take all the other (Ontario) courses first as they are regurgitated within the commercial course making it much easier to digest, therefore easier and in the end more useful, even if like me, you never use it. It’s just good general applicable working knowledge.

    Could you share – on your very well-done website, at the end you briefly address costs, as saying: “Once we understand your unique circumstance, we propose an hourly fee or fixed-fee arrangement to satisfy your needs in the most expedient, cost effective and practical manner.”

    How would your clients know if they were paying appropriately or effectively for such services, thinking typically they would have no way to assess your costs. Not at all meaning to sound disrespectful, just a general question.

    Again, this is a terrific article, as is your website. It seems you have colleague affiliates across the country. Are you able to share who represents you in the Toronto area?

    Cordially
    Carolyne L 🍁

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