WHAT IS A CAP RATE AND WHY DOES IT MATTER?
In commercial real estate, the term “Cap Rate” gets used a lot, but we have found that many people do not know what a Cap Rate is, how it is calculated, or why it matters.
To start with, the term Cap Rate is short for “Capitalization Rate”, and is the calculation of a rental property’s financial rate of return within the first year of purchase. A higher Cap Rate indicates a higher rate of return in year one. These rates are considered a better metric of value than an Return On Investment (ROI) because ROI is determined by how a deal is financed and underwritten, which varies widely. Cap Rates bring a shared understanding of the value of a property. For real estate investors, this piece of information is often critical to their decision making process because it predicts how a property will cash flow assuming the current use/tenant(s). This becomes a key factor for owner investors and owner users alike.
The NOI is the Net Operating Income. An NOI is the net profits from a property, calculated by taking total rent collected minus expenses before debt. This includes things like taxes, lawn maintenance and snow removal. However, Cap Rates do not factor payments to debt service. The NOI is almost always a smaller number than the value of the property. Most investors do not expect a property to return more than its Purchase Price in one year. Additionally, Cap Rates do not factor in any debt that the purchaser assumed in the purchase of the property. This rate assumes that the purchase was made in all cash.
To calculate a Cap Rate, the first year Net Operating Income (NOI) is divided by the price or value of the property.
Cap Rate = NOI / Purchase Price or Value
Or, when viewing it as a function*:
Cap Rate x Property Value
*Using this function, you can calculate any one variable by having the other two.
Things besides Cap Rate that affect an investor’s decision may include the credit of the tenant/user, type of use (risk of turnover, financial stability), and deal characteristics. As an owner considering tenants, riskier users typically require a higher Cap Rate and lower building price, guaranteeing the owner a good return in year one. Inversely, having tenants that have long-term stability and good financial status are the best fit for a lower Cap Rate. Good credit rating and proven financial stability earn a lower risk, and provide a lower Cap Rate and a higher building value.
While a Cap Rate is a useful piece of information, it has its limitations. First, it only predicts the first 12 months from the purchase date. Since most investors purchase properties for longer term planning, other calculations are also needed before an investor can make a decision about the wisdom of taking a particular investment opportunity. And, if a Cap Rate is being applied to a new construction property, it can be difficult to get an accurate number since expenses can be somewhat unknown.
In all, Cap Rates have an important role in the buying and selling of rental properties for investment, and are helpful to understand and be able to speak fluently about.
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