Real Estate Technicals

For Starwood interview

What is a cap rate?

A cap rate is simply NOI / Value. Alternatively, cap rate is the difference between your discount rate and your NOI growth per the Gordon model. It is the same as your going in yield.

What are the three major determinants of cap rates?

The three major determinants of cap rates are opportunity cost of capital, growth expectations, and specific risk.

Why might a property have a low cap rate (e.g., 3.0%)?

It’s a safe, stabilized asset requiring lower returns, or it’s unstabilized with low NOI, evaluated against stabilized yield or mark-to-market cap rate.

Explain how the opportunity cost of capital affects cap rates

Higher real interest rates or expected returns in other investments increase cap rates.

Explain how growth expectations affect cap rates.

Higher expected growth in property cash flows allows lower cap rates.

Explain how specific risk affect cap rates.

Greater property or market risk requires higher cap rates.

You have an office building, a hotel, and an apartment building that all produce the same NOI.

Which one is likely to have the lowest cap rate (and be worth the most)?

Apartment, office, hotel

Why does the apartment building have the lowest cap rate and why is it worth the most?

• Strong tenant credit (people prioritize rent)

• Consistent demand for housing

• Less exposure to market volatility than commercial properties (housing is essential)

Why is the office worth more than the hotel but less than the apartment?

• There are long-term leases, typically, so cash flows are more predictable

• More stable than hotels (since those are daily leases), but more vulnerable than apartments.

Why are hotels worth the least/have the highest cap rate?

• Highly operationally intensive

• Short-term rentals = more volatile revenue (RevPAR)

• Sensitive to macroeconomic factors

• Performance is heavily reliant on management quality

What are circumstances where apartment, office, hotel ranking would change?

• The hotel is a trophy asset in a superior location in a gateway market

• The office has a tenant that is very credit worthy (Apple, Microsoft etc)

• The office has a tenant with a very long lease

• The apartment building is in a neighborhood that is becoming obsolete or susceptible to changing trends (ex. remote work = urban exodus)

What's more important when evaluating a real estate investment - the cap rate or the price per square foot? Why?

• Cap rate shows the income-based return relative to price (based on NOI)

• Price per square foot (PSF) shows the physical value of the asset, ignoring income

• Cap rates can be skewed by unstabilized or artificially inflated NOI

• PSF helps assess cost relative to similar buildings, not performance.

So, use both together — cap rate for return/risk, PSF for asset quality/comparables

Why can cap rates be misleading on their own?

• Based on NOI, which may not be stabilized.

• Some cap rates use 100% occupancy NOI (common in Europe).

• Doesn’t reflect physical size, condition, or replacement cost of asset.

• It could be a very big building producing a low NOI, and so the cap rate is high.

What does price per square foot tell you that cap rate does not?

• Tells you how much you're paying for the physical asset, regardless of income.

• Useful for comparing similar buildings.

• Helps assess replacement cost and market comparables.

• Doesn’t account for income or investment performance.

Two identical buildings (same square footage) are next to each other. One sells at a higher cap rate and a higher price per square foot.

How is this possible?

Because that building has a higher NOI (or NOI per sqft).

Higher income justifies a higher purchase price despite the higher cap rate. If the NOI increases substantially, both the cap rate and price per square foot can rise together. (Even though it’s typically thought to move inversely).

What is the relationship between cap rates and interest rates?

Cap rates tend to rise when interest rates rise and fall when interest rates fall, but the relationship depends on:

1. Capital flows (availability of money)

2. Discount rate mechanics (risk-free rate + risk premium – income growth)

3. Investor behavior and return expectations

How do interest rates affect capital flow in real estate?

• Low interest rates → cheaper borrowing (demand-side) → more capital in system

• High interest rates → tighter lending (supply-side)→ less capital available

• Less capital = lower loan-to-value ratios = reduced property values and higher cap rates

How do cap rates relate to discount rates?

Cap rate = Discount Rate – NOI Growth

• Discount rate = Risk-Free Rate + Risk Premium

• When interest rates (risk-free rate) rise, discount rates rise → cap rates rise

If you think income will grow, you’re willing to pay more today → cap rate is lower

If income won’t grow (or might shrink), you demand a higher cap rate

What’s discount rate?

This is the required return investors want, based on risk.

• Discount Rate = Risk-Free Rate + Risk Premium

So if Treasury bonds (risk-free) are 4%, and you want 3% extra for real estate risk:

→ Discount rate = 7%

What happens to real estate values when interest rates increase?

• Required returns rise (to compete with safer investments like bonds)

• Real estate cap rates go up

• Property prices fall because people pay less for the same income

How do interest rates affect cap rates?

• Higher interest rates = higher cap rates (lower property values)

• Lower interest rates = lower cap rates (higher property values)

• Driven by capital availability, cost of funds, and investor return expectations

Why higher interest rates = higher cap rates?

Higher interest rates = more expensive borrowing

→ Investors need higher returns to justify the deal

→ They’ll only buy at lower prices to hit that return

→ Cap rates go up

Higher rates = tighter capital markets

→ Fewer buyers have access to financing

→ Less competition for deals

→ Prices fall → cap rates rise

Why low interest rate = low cap rates?

Cheaper borrowing = more attractive leverage

→ Investors can pay more for the same income stream

→ Cap rates compress, values go up

More capital chasing fewer deals

→ Bidding wars, strong demand

→ Prices rise → cap rates fall

Why would someone buy a downtown NYC office building at a 3.5% cap rate, when U.S. Treasuries offer a higher guaranteed return?

1. Rent Reversion Opportunity

• Buyer may believe in-place rents are below market, and future leasing will drive NOI higher.

• Even if current yield is low, future income growth would increase value and returns over time.

2. Diversification & Stability

• Real estate offers diversification from bonds/stocks.

• Core, trophy assets with strong tenants and long leases may offer stable, inflation-hedged returns.

• Institutional investors often value long-term safety, not just yield.

What is rent reversion?

When current leases are below market rents, the buyer expects to re-lease space at higher rents when leases expire.

This drives NOI up, raising value over time, even if cap rate at purchase is low.

Why would investors accept a low cap rate on a prime real estate asset?

• Expectation of NOI growth (rent upside, improved occupancy).

• View the asset as low risk, like a “bond proxy” with potential upside (core asset, creditworthy tenants; low-risk, stable income asset that provides stable cash flow (similar to bonds).

• Seeking portfolio diversification, inflation hedge, or capital preservation.

Would you buy a NYC office building at a 3.5% cap rate? How would you make money? What must happen to earn a return?

• Yes, but only if there’s potential to renegotiate leases at higher rents soon.

• Cap rate is already very low (compressed), so returns rely on rent growth (reversion).

• Without rent appreciation, returns will be minimal or negative.

• Must have a strong office brokerage team to efficiently re-tenant at higher lease rates.

• Caution is essential in this low-cap-rate market—opportunities to increase income drive value.

Are real estate investors justified in buying at lower cap rates? Why or why not?

It depends on the investor’s objective and goals — cap rates alone don’t tell the full story.

• If the investor aims to optimize NOI and IRR with room for rental reversion/growth, a low cap rate can be justified.

  A low cap rate might reflect a currently low NOI, so the price may still be reasonable relative to future income potential.

• If the goal is to purchase an ultra-core trophy asset for:

  1. Diversification

  2. Stable cash flow

  3. Capital preservation

  Low cap rates are acceptable because the focus is on safety and income stability, not just high returns.

If you buy a property at a 5% cap rate, put 50% debt on it at 4% interest, what is your levered cash-on-cash yield?

Assuming the property is $100,

• The NOI is $5 (since cap rate = NOI/purchase price)

• The debt is $50 (since 50% of $100 is $50), and the rest is equity (also $50)

• The annual debt cost is $2 (because 4% of $50 is $2)

• The levered cash flow is $3 (NOI - debt cost = $5 - $2)

• So cash on cash yield is 6% ($3/$50; levered cash flow/equity)

What’s the difference between unlevered yield and levered cash-on-cash yield?

• Unlevered yield = NOI ÷ purchase price (same as CAP RATE!)

• Levered cash-on-cash yield = levered cash flow ÷ equity

Leveraging boosts cash-on-cash return because debt is cheaper than NOI yield.

What is IRR (Internal Rate of Return)?

• The discount rate that makes your Net Present Value (NPV) = 0.

• Used to measure the annualized investor return on an investment.

• Commonly used to compare investments and evaluate if returns meet hurdle rates.

What is an equity multiple?

• A measure of total investor return.

• Calculated as:

  (Total cash distributed + sale proceeds)/Initial equity invested

• Shows how many times the initial equity was returned over the holding period.

What does it mean when NPV = 0, and how does it relate to IRR?

• NPV = 0 means the present value of all future cash flows equals the initial investment — you break even at the discount rate used.

• IRR is the discount rate that makes NPV = 0. It shows the annualized return of the investment.

• If your required return < IRR → investment adds value (NPV > 0).

• If required return > IRR → investment loses value (NPV < 0).

• IRR is the “breakeven” rate where the investment’s future cash flows are exactly worth your initial investment today.

What's the relationship between IRR and NPV?

• IRR is the discount rate where NPV = 0.

• IRR discounts future cash flows so their present value equals the initial investment.

You have two deals: one with a guaranteed 300% IRR, and one with a 7% IRR. Which one should you invest in?

• It depends on time, scale, and cash flow multiple.

  • A 300% IRR might be from a $1 investment over one day — not meaningful.

  • A 7% IRR on $50MM over 10 years with a 2.0x equity multiple may be more attractive.

• You must consider:

  • Size of the equity check

  • Holding period

  • Total return (equity multiple)

  • Investor mandate and goals

What is the impact of depreciation on project IRR?

• No impact.

• IRR is based on actual cash flows, and depreciation is a non-cash accounting expense.

• Depreciation may impact taxable income, but not the project’s IRR itself.

What’s a DCF?

A DCF is a valuation method that estimates the current value of a property based on its expected ability to generate income in the future.

It’s useful when cash flows are non-stable or vary over time, unlike simple cap rate methods which assume stable income.

How do you evaluate real estate value generally?

• Human/User Behavior: Trends in demand, tenant behavior, population shifts

• Built Environment: Existing supply, condition, and location

• Financial Factors: Interest rates, capital availability, global investment flows

• Valuation Methods:

  • Sales Comparison

  • Cost Approach

  • Income Approach

  • DCF & IRR Analysis

What are the main valuation approaches for real estate?

• Sales Comparison: Price/sqft vs. comps

• Cost Approach: Replacement cost – depreciation + land

• Income Approach: Value = NOI / cap rate

• DCF: 10-year cash flows + discounted terminal value

• IRR: Discount rate that makes NPV = 0

How would you value each property type?

• Retail / Multifamily / Industrial

  • Cap rate on stabilized NOI

  • Price per square foot

  • Replacement cost

• Hotel

  • Cap rate on stabilized NOI

  • DCF using hotel-specific WACC

  • ADR-based valuation (Average Daily Rate)

What is NOI (Net Operating Income)?

NOI = Operating income – Operating expenses

Steps:

1. Rental income

2. – vacancy

3. reimbursements, overage income, ancillary income

4. – operating expenses (utilities, taxes, etc.)

5. = NOI
   Exclude capital expenditures, TI, leasing commissions

How would you value an office building in downtown NYC?

1. Determine stabilized NOI

2. Apply market cap rate for similar buildings

3. Cross-check with price per sqft and replacement cost

4. Run a DCF with terminal value

5. Ask key questions:

   • What’s the lease roll-over schedule?

   • Who are the tenants? (Credit quality)

   • How much rent upside is there?

   • What are TI and CapEx needs?

   • Is demand shifting in the submarket?