Capitalization Rate Basics

The Capitalization Rate, Cap Rate or Cap, are terms heard quite often in regards to income properties and for this article an apartment building.

A simple definition of a Cap Rate would be a number, specifically a percentage that gives an estimate of the value of an apartment. To determine if an apartment is a good investment, all you need is the Capitalization Rate. But wait! Before you jump to that conclusion you need to look at what makes up a Cap, or what is the formula for a Cap.

The two components of a Capitalization Rate are the Net Operating Income (NOI) and the purchase price of the apartment. The Capitalization Rate is the NOI divided by the purchase price and is represented as a percentage.

Cap Rate = NOI / Purchase Price

NOI = Gross Potential Income - Vacancy and Credit Loss - Operating Expenses

Before I go any further, I need to emphasize one very important consideration involving a Cap as just presented. The "purchase price" is based on an all cash purchase. No loans or mortgages are involved or factored into the calculation.

Using some numbers, let us say that you have been looking at an apartment with an NOI of $100,000 and a price of $1,000,000.

Cap = 100,000 / 1,000,000 = 0.10 = 10%

Three days later your broker calls with another 50 unit apartment building a couple blocks from the 10% Cap apartment building. But this apartment has an 8% Capitalization Rate. Now you have two 50 unit apartments to consider. Your broker also tells you that both apartments have a NOI of $100,000.

You have the Caps and NOIs of both apartment buildings. The only value you don't have is the price of the new 8% Cap apartment. To solve for the price, just rearrange the original formula to;

Purchase Price = NOI / Cap Rate.

The new formula shows how the Capitalization Rate converts the net operating income into a price. Using this new formula, we can calculate what the prices should be for both apartment buildings.

Apartment A Purchase Price = 100,000 / 10% Price = $1,000,000
Apartment B Purchase Price = 100,000 / 8% Price = $1,250,000

We see that the only difference is the cap rate. Both have the same NOI of $100,000. Note that a lower Cap produces a higher purchase price. A 10% Cap down to an 8% Cap, increases the price by $250,000.

You may hear some people equate a Cap Rate to a rate of return for an investment. But is the Cap really equal to the rate of return. Remember, one important component of a Cap Rate is an all cash purchase transaction. No loans or mortgages are involved. But a rate of return will always factor in mortgages or loans.

The leveraged money that is used to acquire a property must be accounted for in any calculation involving a rate of return. Therefore, a Cap based on an all cash purchase can never equal a rate of return. When anyone quotes a Cap, using the basic formula above, understand that it is not the same as a rate of return.