What is a cap rate and why are they important ?

[Isacc Lightbourn]

I hear the words “Cap Rate “ a lot. What is a cap rate and why re they important? Is it something added onto a loan interest rate or maybe equity in a property? What is a good cap rate?

[Neil Henderson]

Cap Rate, or Capitalization Rate, is the expected return on a commercial real estate asset if there were no debt on the property. For example, a property that was purchased for $1 million with no debt, produces Gross Revenue of $200,000 per year, the annual expenses are $100,000, leaving an annual Net Operating Income of $100,000 (Gross Revenue - Expenses). Divide the NOI, $100,000, by the purchase price, $1 million, and you get a Cap Rate of 10% (NOI / Purchase Price). Meaning you can expect a 10% return on your investment of $1 million.

Cap Rate can also be looked at as a function of risk. Investors expect a higher return for investments that are riskier in nature. If you purchase that same property above for $800,000 and it produces the same NOI, it's Cap Rate is now 12.5%. That might sound better, higher return is always better, right? Not necessarily. The purchase price might have come down because the market views the property as over priced.

Cap Rates are often effected by the interest rates. As interests fall, Cap Rates often fall as well, because investors are able to borrow money at low rates, because it theoretically lowers their risk. As interest rates rise, Cap Rates often rise as well.

The power of the Cap Rate can be seen when you start to discuss value-add opportunities. 

For example:

Let's say I purchase that property for $1 million dollars at a 10% cap rate. Through a mixture of increased revenue and lowering expenses, I increase the NOI to $125,000 annually. Divide that new NOI by that 10% Cap Rate and that $1 million property is now worth $1.25 million. Not only did I increase the potential cash flow by $25,000 annually, I increased the value by $250,000. Now, if doing all of the above also made the asset seem less risky to other investors, they might think it's more of an 8 Cap now (8% Cap Rate). In that case, the property is now worth $1,562,000.

It cuts both ways though, let's say all of the above is true, but we have a sudden rise in interest rates that pushes the market Cap Rate to 12%. Now, that property, while we have increased the NOI by $25,000, is only worth $1,041,666.

There really is no way to determine what a "good" Cap Rate is because it depends on the investor's business plan, their goals, and their risk tolerance. 

In self-storage, an A Class facility in a Primary Market (think multi-story, full climate controlled, in a city like Phoenix) might be considered a 5 cap. While a C Class facility in a Tertiary Market (think single-story, over 20 years old, gravel driveway, in smaller town), might be considered a 10 cap.

Again, it's largely a function of risk. Typically, the higher the Cap Rate, the higher the risk, but the higher the potential return.

Personally, I like to look for a Cap Rate that is at least 2% higher than the interest rate at which I am able to borrow, with a significant value-add opportunity.