Tuesday, July 31, 2007

What is a Cap Rate?

Many people ask me what a Cap Rate is when considering commercial real property investments. Cap rate is return on investment and is directly related to amount of investment in dollars and return or Net Operating Income (NOI).

How is the Cap rate related to NOI? NOI is the total income after ALL expenses excluding debt services and taxes. Basically, it is the amount of income you can expect to receive from the property after everything has been paid for. For example, if the apartment building has income of $560,000 per year and all of your expenses excluding debt service (mortgage) and taxes are $480,000. Then, your NOI would be $560,000 less $480,000, which equals $80,000.

How does all these figures get used to determine my return you ask? Let's plug in all the numbers.

  • To calculate the Cap Rate for a listed property: Divide the NOI by the listing price to calculate the Cap Rate in decimals.
  • To calculate what to list the property using 8% Cap Rate: Divide the NOI by the desired Cap Rate in decimals.
  • To calculate the NOI for a listed property with listed Cap Rate of 8%: Multiply the listing price by the Cap Rate in decimals to determine the NOI.

Now that we know how to calculate the Cap Rate, let's discuss why it is an important tool and what exactly it does.

Cap Rate is a return on investment and does not relate specifically to the amount of cash you have in the investment. It just calculates what percentage you can expect in return for the amount you paid for it. Whether you have paid it cash or have financed 100% of the investment, the Cap Rate will remain the same. This is due to NOI being calculated prior to debt service or taxes. The reason for this is that different investors have different debt service criteria and are in different tax brackets. For Example: If you purchased a property for $1,000,000 and the property's NOI is $100,000. Then, the Cap Rate per above calucation is 10% (Divide the NOI by the listing/purchase price). This tells us that this property will produce an NOI of 10% of the investment. Now, using the same example as above with different NOI of $80,000. The new Cap Rate will be 8%. This tells us that this particular investment will produce 8% return.

From the examples, notice that the Cap Rate is important in determining value of the property to you. Also note that as the Cap Rate gets higher using the same NOI, the price or value gets lower. Conversely, as the Cap Rate gets lower using the same NOI, the price or value gets higher.

Remember: Cap Rate is a rate of return. To obtain a higher rate of return, you have to purchase the property cheaper. Another example is if the property is in an area that is not as desirable. These properties will have higher Cap Rate, which will give you higher rate of return.

  • Property 1: Suburban neighborhood and highly desirable area: NOI of $100,000 and lower Cap Rate of 7%: Value/Price is $1,428,571.
  • Property 2: Not as desirable neighborhood with high tenant vacancy: NOI of $100,000 and higher Cap Rate of 10%: Value/Price is $1,000,000.

As you can see from above calculation, buyers of Property 1 will usually seek lower rate of return due to its location. Buyers of Property 2 will seek higher rate of return for additional risk they are taking.

Summary: Cap Rate is a rate of return on your investment and is related to NOI and purchase price. Cap Rate is calculated as a decimal (7% is .07). Cap Rate varies by neighborhoods and markets. Generally, lower Cap Rate is good for sellers and higher Cap Rate is good for buyers.


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