Cap rate plus growth is an exact identity for a frictionless asset sold on its entry yield, and a ceiling for every real one.
Only in a frictionless case. If income grows at a constant rate, nothing is spent on the building, there are no transaction costs and the property is sold at the cap rate it was bought on, the unlevered IRR equals the going-in cap rate plus growth exactly: 5.50 plus 2.0 is 7.50 per cent. Add illustrative purchase costs, sale costs, a capex reserve and an exit 50 basis points wider, and the same asset returns 5.23 per cent, 2.27 points below cap rate plus growth.
Worked in full in Commercial Real Estate Investing by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
"Cap rate plus growth" is the quickest return estimate in real estate, and it is used in investment committee papers, in house views and in conversations about whether a market is cheap. It is a good identity and a poor forecast. The calculation below shows when it holds exactly, and then prices each of the things that make it overstate the return.
| Input | Value |
|---|---|
| Price, before costs | 100,000,000 |
| Net operating income, year 1 | 5,500,000 |
| Going-in cap rate (year 1 NOI on price) | 5.50% |
| NOI growth a year | 2.0% |
| Hold | 10 years |
| Purchaser's costs / sale costs | 6.8% / 2.0% |
| Capex reserve, share of NOI | 10% |
Valuet = NOIt+1 ÷ cap rate
Return in year t = NOIt ÷ Valuet−1 + (Valuet ÷ Valuet−1 − 1) = cap rate + g
In Excel, put the price as a negative in year 0, NOI growing at g in years 1 to 10, and add =NOI_year11/cap to year 10; =IRR(B2:B12) returns exactly cap + g.
If the property is always worth its next year's income divided by the same cap rate, its value grows at the income growth rate. Each year the investor earns an income yield of exactly the cap rate on the opening value, plus capital growth of exactly g. Here the year 10 NOI is 6,573,009, year 11 is 6,704,469, and the sale at 5.50 per cent fetches 121,899,442. The IRR on those flows is 7.50 per cent, to the basis point.
| Case | Unlevered IRR | Change, points |
|---|---|---|
| Frictionless: cap rate + growth | 7.50% | |
| + purchaser's costs of 6.8% | 6.62% | −0.88 |
| + sale costs of 2.0% | 6.46% | −0.16 |
| + capex reserve of 10% of NOI | 5.93% | −0.53 |
| + exit cap rate 50 bp wider | 5.23% | −0.70 |
Purchase costs are the largest single item: 6,800,000 paid on day one that earns nothing and is never recovered, so the investor's real entry yield is 5.50 divided by 1.068, about 5.15 per cent, not 5.50. Capex is the one most often forgotten, because NOI is quoted before it, yet a building that is not maintained will not hold its cap rate. The exit yield assumption is the most debated, and 50 basis points of widening over ten years is a modest allowance for an ageing asset. Together they take 2.27 points off the headline.
| NOI growth | Exit at 5.50% | Exit 25 bp wider | Exit 50 bp wider |
|---|---|---|---|
| 1% | 4.94% | 4.58% | 4.25% |
| 2% | 5.93% | 5.57% | 5.23% |
| 3% | 6.92% | 6.56% | 6.22% |
Growth passes through almost one for one: a point of growth adds about a point of IRR in every column. Exit yield costs roughly 0.35 points of IRR per 25 basis points over a ten-year hold. Even at 3 per cent growth and an unchanged exit yield, the asset returns 6.92 per cent, not the 8.50 per cent cap rate plus growth suggests. On these assumptions the frictionless sum overstates the real return by about 1.6 points before any view on yields is taken.
The rule fails in a second, quieter way on assets that are not let at market rent. An over-rented building's cap rate includes income that will fall at the next review; an under-rented one has growth to come that the cap rate does not show. The equivalent yield is the measure that deals with that.
Cap rate plus growth is the IRR of a frictionless asset sold on its entry yield: 7.50 per cent here. A real one, with 6.8 per cent purchase costs, sale costs, capex and a modestly wider exit, returns 5.23 per cent. Build the cash flow, as in the free workbooks for Commercial Real Estate Investing, and use the sum only as the ceiling it is.
When NOI grows at a constant rate, nothing is spent on capex, there are no purchase or sale costs, and the exit is priced on next year's NOI at the entry cap rate. Value then grows at the growth rate and income yields the cap rate each year. The illustrative 5.50 per cent cap rate and 2.0 per cent growth give an IRR of 7.50 per cent exactly.
On a ten-year hold of the illustrative asset, purchaser's costs of 6.8 per cent, 6,800,000 on a 100,000,000 price, reduce the unlevered IRR from 7.50 to 6.62 per cent, 0.88 points. They cost more on shorter holds, because the same sunk cost is recovered over fewer years.
On the illustrative ten-year hold with costs and a capex reserve, about 0.35 points of IRR per 25 basis points of exit widening: 5.93 per cent at an unchanged 5.50 per cent exit, 5.57 per cent at 25 basis points wider and 5.23 per cent at 50 basis points wider.
This article is one calculation from Commercial Real Estate Investing. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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