The great CapRate Fallacy

[Jeff B.]

CapRate is a derived number, not one on a PnL, Balance Sheet or COE Settlement Statement. It is a measure of the effectiveness your purchase.

We all know the metrics NOI, PurchasePrice and CapRate and the math is trivial to calculate

• (1) NOI / PurchasePrice = CapRate

and simple algebra allows us to express other variations:

• (2) CapRate * PurchasePrice = NOI
• (3) NOI / CapRate = PurchasePrice

Mathematically, all three equations are correct - - however, only ONE is valid!
First, let me rewrite the first one this way:

(1) NOI / PurchasePrice -> CapRate

which is read NOI divided by PurchasePrice DETERMINES the CapRate
and this is the only operationally valid expression of the three.

As each property has a unique Purchase Price and from its operational expenses also has a unique NOI, No two properties will derive the same CapRate. Oh sure by coincidence, variations in both the NOI & the Purchase Price will derive the same ratio, but that does not mean every property in the City of Mayberry will end up with this same ratio.

It is a mistake to assert that CapRate determines anything, let alone an NOI.
For example, (2) might be said to determine the NOI, which is fallacious as the rents and operational expenses to that

• (4) GSI - Expenses -> NOI

Likewise, and we hear these on BP all the time,

• "CapRate determines the Purchase Price".
• "Which Cities have the best CapRates?"

Cities do not have an NOI and thus can never have a CapRate.

My RE Agent may advertise my property with a CapRate and a Purchase Price and from these the buyer can calculate a NOI as stated by the seller. The NOI needs to be verified and after the sale, the buyer's NOI will likely be different if only because of Property Taxes and Insurance costs. The CapRate WAS an indication of the NOI, but If I the seller change my price (up or down), then the CapRate changes. I don't change the CapRate to derive a new Purchase Price. Altering the NOI and Purchase Price WILL change the CapRate for the buyer.

[Jeff B.]

Should have noted:

• Cities do not have an NOI and thus can never have a CapRate.
• Also Cities do not have a Purchase Price and thus no CapRate

While figures don't lie but misuse of figures is LIKE lying, even if it's unintentional.

[David Dachtera]

What is CapRate?

Remember that it's short for "Captialization Rate".

What is "Capitalization"?

Simply (and, perhaps, somewhat inaccurately) stated, it's how long it takes for the building to pay for itself or how well it covers its own expenses. The lower the number, the quicker the pay back and the better the cash flow. The higher the number, the slower the pay back and less the cash flow.

... and while it's true that the locality does not DETERMINE the CapRate, the commercial rental properties in an area will all have a CapRate of some kind. How broad the range is the question and whether, upon financial analysis, a prospective acquisition falls within that range can help determine how much of a sound investment that specific piece of property might be.

If outside that range, especially on the high side, does not necessarily mean it's not a good investment.

CapRate is only one factor to consider when analyzing a commercial RE deal, and even then, it's the quotient of two other factors and not itself a direct determinant.