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Investment Perspectives: The theoretical construct of the capitalisation rate, and why it matters

At Quay, our approach to global real estate investing is somewhat different to our peers. 


For instance, we don’t place much weight on the Net Asset Value (NAV) of companies – discount or premium. In fact, we have previously explained many of the shortcomings on NAV investing when assessing total return.

That’s not to say NAVs aren’t useful. It’s just that we prefer to assess NAV based on a fair capitalisation rate, rather than rely on comparative transitions which may or may not meet our investment criteria.

The capitalisation rate

The capitalisation rate is a number, expressed as a percentage, which is applied (as a denominator) to normalised net property income to calculate a gross (unlevered) asset value. Analysts then deduct debt and make other adjustments (work in progress, land, other business) to derive a ‘fair’ NAV for a particular share or company.

Limitation of the capitalisation

The capitalisation rate is the inverse of an EBITDA multiple (before head office costs). It is a highly abbreviated discounted cashflow model based on a geometric progression. That is, assuming the cash flows grow at a consistent rate (say g% per annum), then to achieve a total return (r%):

Cap rate = r – g

Assuming the long run growth of the cashflows is inflation, the cap rate is a proxy for a real unlevered total return (assuming the ‘stay in business capex’ is zero).

In most valuations, a fair capitalisation rate is based on comparative sales. The theoretical reasoning is that the NPV analysis conducted by the buyer and seller of the observed sale was rational, and therefore the same metrics can apply to similar property.

Such an approach leans heavily on the belief in ‘efficient markets’ – something any active investor should question.

The main problem with this approach to the comparable capitalisation rate is that it’s backward-looking. As such, it tends to exacerbate the property cycle as the trend in cap rate movements are extrapolated, resulting in higher peaks and lower troughs.


The construct of a fair capitalisation rate?

Comparable pricing can be valuable. When most people buy a house or apartment, recent transaction evidence can provide comfort for both the buyer and seller (not to mention the lender). In the world of ‘relative performance’, buying cheaper than the next person is a technique that assists in performing better than an index-based benchmark.

At Quay, we don’t attempt to match or beat an index. We gain no comfort in the event of losing less money than the next person, so comparative pricing and capitalisation rates hold very little value in our approach.

Instead, we focus on our absolute total return of CPI + 5%. Using this benchmark, we can turn to the theoretical construct of a capitalisation rate to assist in identifying opportunities that can at least meet our investment objective.

  • Our approach to the fair capitalisation rate is derived from the long-term dividend discount model, where:
    • Total return = free cash flow yield + long-term growth (inflation + real)
  • Which can be extended to:
    • Total return = cap rate – stay in business capex (‘SIBC’) + long-term growth (inflation + real)
  • Deducting inflation from both sides:
    • Total real return = cap rate – SIBC + real growth
  • Assuming a minimum required 5% real total return, the equation can be re-written:
    • Fair cap rate = 5% + SIBC – real growth

As discussed, the capitalisation rate assumes a zero rate for stay in business capital expenditure (SIBC). In real estate this is rarely zero, and never consistent across asset classes. It is therefore a very important input in our process.

SIBC and real growth rate adjustments are individually assessed as part of our proprietary screening process. This allows us to rank real estate companies globally in both relative and absolute terms. That is, companies that do not meet our real return hurdles are excluded from further analysis, while the remaining companies are ranked from best to worst.[1] This represents the first step in our five-step investment process.

How does this affect Quay’s investment approach?

When we launched the Global Real Estate Fund in 2014, our research indicated US retail space per capital was significantly greater than every developed market. Further, there was a real risk e-commerce would act a significant headwind for the sector, which we believed would:

  • Reduce long-term real growth prospects, and
  • Increase defensive (stay in business) capex.

In our opinion, both factors would increase mall capitalisation rates relative to history.

As a result, our screening process showed the total return from US malls was unlikely to meet our benchmark. Consequently, for the first three years of existence the Quay Global Real Estate Fund held no US listed mall exposure.

While it is now fashionable to call for the retail apocalypse, at the time of our Fund launch in July 2014 this was a non-consensus call, because most market participants relied on historic transaction-based cap rates, suggesting these companies had higher NAVs. We were not convinced.

The theoretical cap rate can tell us when risks are correctly priced

Despite the significant underperformance by US mall REITs over the past two years, we were rarely tempted to review the sector because our screening process concluded the pricing did not reflect the lower real growth outlook or the risk of higher capex. That was until July this year, when GGP Inc screened in our top 40 for the first time. Whenever a stock screens this high (out of around 280 securities from our defined universe), we see opportunity.

After undertaking financial due diligence, reviewing the company strategy and undertaking our usual deep dive analysis, we concluded the risks were appropriately priced and we began to accumulate a small position for the Fund.

In the following months, the major shareholder offered a substantial take-over premium to our entry price. It appears our investment will be short-lived, albeit profitable.

Concluding thoughts

The world is a big place, and our investment universe is large – typically 280+ listed companies representing almost A$2 trillion in market capitalisation. Like many investors challenged by a wide opportunity set, we employ quantitative screening techniques to find value efficiently. We believe understanding the theoretical construct of the capitalisation rate helps in this process.

This may all sound a little academic. However, we believe it forms an important part of finding the best investment opportunities globally that meet our investment objective. Our experience with the US mall sector shows it can assist in preserving capital and pricing risk.

[1] We also include “growth” factors in our screen.  For more information, contact us.

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