5 Things you need to know about cap rates and multiples in valuations

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.

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 ofcapital 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.

Tags: Cap rate,commercial lending, valuations, commercial mortgage