Can anybody explain to me what CAP RATE (%) is?

Question

I'm still confused what CAP Rate (%) means? Anybody have any good explanation? (with examples? Thanks a bunch in advance.

Llewelyn A. · Answer

@Jeff Greenberg <---- see further down.

I agree with the three posters above me.

I wanted to add to this conversation, however.

There are actually two ways to use Cap Rate, Both ways work as a Comparison to know if you are over paying or getting a deal. Here is how it can and should be used:

1) Analyzing if you are over paying for you Investment by Comparing ONLY Cap Rates.

In this example, let's take two properties, A and B. Both are very similar. The details of A and B are as follows:

Property A

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Selling Price: $100k

NOI (Rents minus Expenses excluding Debt Service) = $8k.

Cap Rate = 8%

Property B

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Selling Price: $234,124

NOI: 26k

Cap Rate: 11.1%

This tells you that Property B is a bit better than Property A because you will make approximately 3.1% more ROI annually, excluding Debt Service. I used a strange selling price so I can show that both A and B may have crazy numbers but you can boil them down to just the Cap Rates and compare them easily.

HOWEVER, we must then compare the neighborhoods.

Property A is in a GREAT Neighborhood. In fact, it is in an A Class Neighborhood where you are extremely likely to find good tenants all the time and will have very consistent and increasing cash flow through rising rents. In other words, the QUALITY of the Cash Flow is excellent.

Property B is in a terrible neighborhood where there is so much crime, you will need to bring your bullet proof vest when you visit your property! It's the War ZONE!

Now we need to look at the RISK of the Cash Flow.

Hypothetically, let put Property A in NYC in a very LOW Risk or HIGH Quality area say Brooklyn Heights. You are getting an 8% Cap Rate in this neighborhood. If we compared Brooklyn Heights, generally, the neighborhood is around a 3% Cap Rate. Let's call that the Neighborhood Cap or NCap for simplicity sake. If you are getting an 8% Cap Rate in a 3% NCap neighborhood, you are doing FANTASTIC! How Fantastic?

So, if you use Jeff's calculations of NOI / NCap to get the actual Fair Market Value (FMV) of the property you are targeting which is Property A, you get $8k / 3% = $267k versus the actual Selling Price of $100k! That's a GREAT Bargain because you are assured that you will get much more than that if there are no conditions that offset that difference!

Now, let's take a look at Property B in the War Zone in Brooklyn, say Brownsville area. Because of the risk of the Cash Flow, most properties in this area are really selling for around 15% NCap because at any time, you may lose the ability to get the cash flow either through eviction, high crime, lack of response from police or fire dept, etc. In other words, for you to take on greater risk, you MUST get greater compensation via a higher NOI translating to a higher Cap Rate.

Using NOI / NCap again, we get $26k / 15% = $173k! Woah! But it is selling at $234k! You are getting ripped off because of the Quality of the Cash flow!

Really, you need to take into account BOTH a comparison of your Cap Rate to the target properties AND the RISK of the neighborhood using the Neighborhood's Cap Rate. You need to get compensated for the Risk you take!

As an aside to buying properties in lower Cap Rate areas, there is a trade off of LACK of Cash Flow when compared to higher Cap Rate areas. BUT, it is generally the case that you are compensated in several ways when you buy at lower Cap Rates. Accepting a lower Cap Rate needs to also be compensated with higher Rents later on, increasing your Cash Flow and translating to higher Property Values as a result.

In other words, don't buy Low Cap Rate Properties without a good probability that you will be compensated with increases in stable future rents and increasing stable cash flows.

As an aside, I buy in Brooklyn, usually with around 5% Cap Rate properties. However, as the rents move up, if I were to recalculate the Cap Rate after locking in the Buy Price where I purchased the Property, over time, my personal Cap Rate will be GREAT. In most of my properties, my personal Cap Rates exceed 20% since I bought the property with today's rent roll.

If I were to sell today, I don't use my personal Cap Rate at purchase, I use the current Neighborhood Cap Rate and my current NOI which is much higher than the NOI at purchase. That translates to incredible appreciation. This is why the few of us who buy in places like NYC or SF are perfectly fine with low Cap Rate properties. We are paying a premium in order to have consistent cash flow increases over a long period of time.

Jeff Greenberg · Answer

I think the calculation that is most important when using the cap rate, is finding the value of the property. If you know the cap rate for the market and type of property and you know the noi you can value the property.

Noi/cap = value

100,000/.10(10 cap)=1,000,000

100,000/.07(7 cap)=1,428,571

You can see the effect of a lower cap rate.

Brent Coombs · Answer

@Peter Kim, in case you're not aware, cap rates are relevant to COMMERCIAL properties (only).

If you're thinking about properties that can get owner-occupier loans (single family to 4plex residences), then only COMPARABLE sales (known as comps) are relevant to work out their market value, not cap rate. Cheers...

Account Closed · Answer

@Peter Kim The Cap Rate = Capitalization rate. You want to be careful with this because there can be different sects within the field of finance that use the word/concept differently to describe different things.

If you are familiar with the income statement, you want to think of the cap rate as a measurement tool just like you would the profit margin.

With the profit margin you can compare the profitability (management effectiveness) of similar companies within an industry. Similar with the cap rate, you can measure the quality of earnings from an RE investment.

Extremely low caps = probability of negative cash flow = bad for investor seeking income today. Above average caps = probability of positive cash flow = good for investor seeking income today.

Just like with a profit margin, the higher the cap rate, generally the better and higher net cash flows. Cap rates generally have to exceed mortgage rate on property for property to realize a positive cash flow if 80% or more of the property value is financed with debt.

David Dachtera · Answer

@Peter Kim,

"Cap Rate" is the Capitalization Rate of an income property.

Essentially, how fast / well the building pays for ("capitalizes") itself through its rental income. The higher the Cap Rate the better. The higher the Cap Rate the faster the building will pay itself off. The higher the Cap Rate the better your cash flow before debt service.

You can use Cap Rate as something to compare to other income properties around it. If a particular investment you're considering produces income which yields a Cap Rate similar to surrounding properties, then by making that comparison you can tell how it stacks up compared to those other properties. You will still need to make subjective judgements about that, of course, taking all the other factors into consideration.

Dunno if that helps ...

Peter K. · Answer

Wow, great. Thank you all for providing great examples! I appreciate everyone's explanations.

Ben Leybovich · Answer

The formulas have been covered pretty well in the previous responses. Let me see if I can add to the rationale.

Capitalization Rate is a market-driven metric which tells us how investors behave in terms of deploying capital to buy income. Let's look at the basics:

If you are prepared to deploy capital so long as you can reasonably plan on receiving a 10% return on your money, then on a building that supports a return of $5,000 per annum you would be willing to pay $50,000 -- $5,000 represents 10% of $50,000, right? So, in this case the 10% is the capitalization rate.

Now, it's important to define that figure of $5,000. It's not simply the top-line income. Relative to the capitalization rate this is what we call Net Operating Income (NOI). NOI is income minus expenses, but not including debt service. Not including the debt service into this equation helps us compare apples-to-apples.

So, this building that throws off $5,000 of NOI likely generates $9,000 - $11,500 of top-line income. Then you pay the costs of running this asset and you're left with $5,000 out of which you pay debt service (if there is debt) and put the rest in your pocket as cash flow.

The reason Cap Rate is important is because if we invert the formula we are able to place a value on the asset using the estimated NOI and the known cap rate coefficient, just I did in the example above:

If you are willing to buy a building which generates $5000 of NOI so lang as you can project 10% return (which in this case is the cap rate), then you'd value this acquisition at $50,000. But, if you are satisfied with 8% return then you'd be willing to pay $62,500 for the same building (8% of $62,500 is $5,000). If you demand 12% return then the most you'd pay is $41,667, etc.

Now -- the importance of this is that as you look at the marketplace and are able to see what other investors pay for income, you are able to get a sense of the "appetite and risk tolerance" in the marketplace. So the Cap Rate is a market-driven metric in this way. And on the other hand, this tells you what you need to do to beat the market...

Finally, the convoluted aspect of all of this is that if you know what the hell you are doing you would use the Cap Rate in other ways but never as a trigger for the decision to buy. A lot more rationale is needed...

Hope this helps a bit. Good Luck!

Jeff Greenberg · Answer

To the point: cap is only one data point to assess the value of commercial properties. Job growth, population growth, crime, etc.

Russell Brazil · Answer

Net operating income divided by the value of the building equals cap rate.

Very simple example.

Building valued at $100k.

Gross rent is $20k.

Operating expenses  $10k.

Net operating income (Gross rent minus expenses) is $10k.

NOI of $10k divided by building value of $100k equals a 10% Cap Rate.

Can anybody explain to me what CAP RATE (%) is?

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