A Cap Rate or Capitalization Rate is a rudimentary way of calculating an investment property’s return.
A Cap Rate, or Capitalization Rate, is a commonly used metric to analyze an income-generating real estate investment. It is defined as a percentage that relates the price of an income-generating property to one year of its future income, expressed as Net Operating Income (or NOI) divided by Price.
Cap Rate = NOI / Purchase Price
A very simple example is a property with an NOI of $100,000 and a price of $1,000,000: that property’s Cap Rate is 10%.
A Cap Rate captures the annual return on investment that one might expect in the first year of ownership. It is a one dimensional metric that does not account for performance beyond the first year. Nor does it always account for up-side or additional rent that may be realized in the future. In addition it does not take into consideration leverage (debt), length of lease term, rental escalations, future sales price, or after-tax returns. Though a Cap Rate, by many counts, is a rudimentary measurement of return, it is commonly used because it is easy to calculate and understand.
When an investor knows any two of the three components of the Cap Rate equation, he or she can solve for the third component. For example, if an investor knows that he wants a 10% return, and that a property generates $85,000 NOI, he can then determine that he would pay up to $850,000 to purchase that property. In other words, $85,000 is 10% of $850,000.
In order for a Cap Rate to be an effective measurement of return, one must first determine clearly a property’s Net Operating Income. Unfortunately, the NOI is often misquoted and misunderstood. The NOI is defined as the potential rental income less vacancy, credit losses and operating expenses. It is important to understand the vacancy rate which is applied, making sure that it is consistent with the market and reality. In addition, it is important to confirm that all operating expenses are accounted for, including taxes, insurance, maintenance and management expenses. Failure to include all the appropriate expenses to determine an NOI can result in significant mistakes and skewed pricing.
There are many other metrics used to analyze an investment property. The Cap Rate is just one way. In fact, many sophisticated investors would say that the Cap Rate is not the determinant of property value, but rather the result of dividing NOI by price, after all other factors and metrics are considered.
Professional commercial real estate advisors add tremendous value to both buyers and sellers of commercial real estate investments. Contact one of the team members at New Branch Real Estate Advisors to discuss your real estate investment objectives, cap rates and other ways to analyze real estate investments.