Cap rates make no sense

[Sylvia B.]

I've read this article by Sergio Altomare - How to Calculate Cap Rate (& Where Many People Get It Wrong) several times and there is something that just doesn't make sense to me. 

These basic formulas do make sense:

• NOI / Cap Rate = Property Value
• Property Value x Cap Rate = NOI
• NOI / Property Value = Cap Rate

However, an example is given where the NOI is increased by either raising rents or decreasing expenses, and then this comment is made:

"In the above examples, you can really start to see the power of using the cap rate in the analyses. You bought a property for just over $900K, increased the NOI by $5K/year and have now increased the value to $1M!

The reason this happens is simple. The market dictates the cap rate, and the cap rate is based on the NOI. In this case, the cap rate at purchase and sale remained the same, but the NOI was raised by 10 percent."

What makes no sense to me is why the cap rate remains the same. It seems rather arbitrary. "The market dictates the cap rate, and the cap rate is based on the NOI." Those two phrases seem contradictory to me. If the market determines the cap rate (in some unexplained manner) then it is not based on the NOI.

Perhaps what I don't understand is how the market determines the cap rate.

[Immanuel Sibero]

@Sylvia B.

That's very perceptive of you. Yes you are correct about the statement "The market dictates the cap rate, and the cap rate is based on the NOI." not making sense because it doesn't. That statement is comprised of two paragraphs that contradict one another.

The formulas you quoted from the article:

• NOI / Cap Rate = Property Value
• Property Value x Cap Rate = NOI
• NOI / Property Value = Cap Rate

need further explanations. As they are written, those formulas are logically circular (i.e. Value depends on cap rate and cap rate somehow depends on value also. It's like watching a dog chase its own tail)

There are two types of cap rates - the "property" cap rate and the "market" cap rate. The "property" cap rate is calculated by taking the NOI divided by the value(usually cost) of the property in question. So this type of cap rate differs from property to property. The "market" cap rate is NOT calculated, it is determined by the market (as the name suggests). This is the cap rate that you obtain from the market participants i.e. commercial brokers, lenders, investors, etc. This cap rate is really a measure of investors sentiment towards the local real estate when it comes to their expectations, outlook, etc. In other words, it's a measure of how desirable the investors think the properties are in a specific market. For example, the more investors like the economic prospects of a particular market the more they are willing to pay and the lower the "market" cap rate goes. THIS cap rate is the cap rate that should be used when it comes to valuing a property NOT the "property" cap rate that the article seems to suggest.

This "market" cap rate SHOULD be the one that is referred to in the formulas above, so I can rewrite them as follows:

• NOI / market Cap Rate = Property Value
• Property Value x market Cap Rate = NOI
• NOI / Property Value = market Cap Rate

Note: again in the above formulas, "market" cap rate is determined by the market, it's NOT calculated as the article implicitly suggests. Since cap rate is GIVEN, you can see the formulas above are no longer circular. I don't know how many "cap rate" articles, blogs that simply miss this concept to the point that I question the authors' understanding.

Cheers... Immanuel