Understanding Cap Rates

There are certain financial measurements that are commonly used in the field of commercial real estate, and for better or for worse, capitalization rates, or cap rates for short, are perhaps the most common. Unfortunately, many people do not truly understand what a cap rate is and what it is not.

I’ll openly admit that the concept of cap rates used to confuse me. I knew they were important and I knew that the calculation was simple enough, but I still had trouble appreciating what a cap rate meant. This article will hopefully provide some clarification to anyone else struggling to comprehend what exactly a cap rate tells you.

What a Cap Rate IS

In short, a cap rate is a way to measure the risk/return profile of a particular investment as compared to comparable properties. To more fully understand this, let’s break down the two parts to that definition.

Starting with the second part of the definition, it’s important to understand that a cap rate compares a property to other properties in the market. This means that to understand a cap rate, you need to understand the current, broader economic and market conditions. A particular cap rate, whatever the number may be, may be considered high today but low twenty years from now. When you determine the cap rate for a subject property, it must be compared to the rest of the market.

The first part of the definition tells us that a cap rate measures the risk/return profile of an investment property. While the market context matters in terms of what actual number would be considered high or low, a relatively high cap rate suggests a higher level of risk and return. Like most investments, the higher the risk, the higher the return. These two things go together. If you’re willing to take on more risk, you expect a greater potential return in exchange for that risk. Conversely, a relatively low cap rate suggests both a lower risk and a lower return.

What a Cap Rate is NOT

There’s an important point here where many people get confused. Notice that the definition suggests that a cap rate is a measure of the risk/return profile. It would be an oversimplification at best to say that cap rates are a measure of the expected return. That said, many people will still use cap rates as an measure of expected return.

Additionally, cap rates are measured at a distinct point in time. This means that they do not consider the time value of money, or the fact that a dollar today is worth more than a dollar tomorrow. A more appropriate measure of the anticipated return on your investment would consider when you pay for an asset and when you receive its financial benefits (i.e. when you pay for a property and when you make money from that property).

What Cap Rates Tell You

As mentioned, cap rates are a measure of the risk/return profile of a subject property compared to the market that it exists within. Thus, they are a relative measure.

A high cap rate suggests that there may be less market stability, a higher potential return, and that you’re paying a lower price for a given source of income or put another way, getting more for a given price. Higher cap rates are also associated with higher interest rates and more risk tolerant investors.

A low cap rate by comparison, suggests that there may be greater market stability, a lower potential return, and that you’re paying a higher price for a given source of income or otherwise, getting less for a given purchase price. Lower cap rates are also associated with lower interest rates and more risk averse investors.

How is a Cap Rate Calculated?

Mathematically, calculating a cap rate is quite easy. It’s simply the net operating income divided by the value of a property. The Net Operating Income (NOI) is a measure of how much money a property generates on an annual basis. It considers rental and other income and then subtracts operating expenses along with an allowance for vacancies.

The value of a property should be the current market value, such as would be prepared by an appraiser. However, as a shortcut some people will use the purchase price or asking price. A purchase price however may be outdated, especially if a property was purchased some time ago. Similarly, a person could have underpaid or overpaid for a property. Furthermore, the asking price is not the same as the market value, since most people expect to negotiate and thus start with a list price above what they intend to settle for.

Using the wrong figures, such as not properly calculating the NOI or using a purchase price instead of the market value of a property can provide you with a skewed cap rate. Remember that in math, the results are only as good as the inputs.

What is a “Good” cap rate?

In answering this question, we’re again reminded that cap rates are a relative metric. As a result, what constitutes a high, low, good, or bad rate is relative and depends on a number of variables.

Just as a residential real estate sales agent would look at comps or comparable properties to determine what to sell a house for, a commercial real estate investor should study the market to determine what constitutes a high or low cap rate. This means determining what the market is and then assessing comparable properties within that market.

For example, you want to compare the cap rate of your subject property to the typical cap rate for other properties that are similar in terms of traits such as asset type. Properties may be residential, office, industrial, retail, hotel, mixed-use, etc. Similarly, you’ll want to consider quality (such as Class A, Class B, Class C, etc.), the location of a property (rural vs suburban, primary vs secondary city), and the timing. Timing refers to whether you want to examine current cap rates, historic rates, or anticipated future rates, such as when you plan on selling at some point down the road.

Once you determine what the market is, you can turn to market research either done by someone else or that you conduct yourself to ascertain what a typical cap rate is for your subject property’s market. Next, you consider your tolerance for risk and the level of return that you need to make an investment work. Only by putting all of this information together you’re able to determine what a “good” or “bad” cap rate is.

An Example of Cap Rates in Use

Let’s say that you’re looking at purchasing a hotel in a mid-sized, US city, within its urban center. The property is in excellent condition, has an excellent reputation, and is frequently sold out. Also, since you’re currently only interested in the right now value since you plan to hold and operate the hotel indefinitely.

You pay for a service that has already conducted the research and assimilated data from other similar properties and it turns out that cap rates currently hover around 7 to 7.5%. From the current owner you’re then able to find out that the hotel annually produces $585,000 in NOI. The asking price is $8,200,000 and you want to know if that’s a fair price.

Using a little mathematical manipulation, we take the formula for calculating cap rate and move the variables around so that we can instead solve for value. We do this by dividing the NOI by the cap rate. 585,000 divided by 7.0% equals $8,357,143 and 585,000 divided by 7.5% equals $7,800,000. Therefore, based upon the assumed risk and the anticipated income you expect to receive, the value of the property and thus the price you should pay should be between $7,800,000 and $8,357,153.

Thus, what the cap rate provided you was a means of comparison. It allowed you to compare one property to other similar properties.