CAP RATE Explained! What, How, & Why.

What the heck is a Cap Rate!?

I will always remember the first time I hear the term "Cap Rate", it made me entirely question my decision to get into real estate. I hear my boss say it the first day on the job when I made the switch into real estate. 

I had no freaking idea what he was talking about and I was too afraid to ask, for fear of sounding stupid. 

*SIDE NOTE: Never do that, never be too afraid to ask a question. You will never be thought down on for asking a genuine question, to gain knowledge.

So fast forward to this post today, I am going to save you that pain/fear and shorten the learning curve, by explaining to you a quick explanation of just what exactly is a Cap Rate, and how it is used to Value Commercial Real Estate. 

Thank you for tuning in, again, Cap Rate time!... 

Definition: Capitalization rate, commonly known as Cap Rate, is a rate that helps in evaluating a real estate investment. Cap rate = Net operating income / Current market value ( sale price ) of the asset.

As seen in the equation above, the way we arrive at the Cap Rate is by dividing our Net Operating income by the purchase price of the property.  

If our Net Operating Income ( NOI ) is $50,000, and our purchase price is $1 million. 

We take $50,000 ( NOI ) / $1 million ( Purchase Price ) = 5% ( Cap Rate )

So now you know how to find the Cap Rate on a property but what do they mean? How do you analyze the Cap Rate for a property, how are they used in Real Estate valuation? 

You are in luck, cause that's right! I am about to tell you. 

Cap Rates are a foundation in the valuation of Commercial Real Estate, Cap Rates are very dependant on specific markets and geographic areas, and they are a way to compare similar properties in that specific area. 

A good rule of thumb is the lower the Cap Rate the more stable the area, examples:

Core Markets like San Francisco and Manhattan are going to have very low Cap Rates as those markets are considered very stable with high appreciation. These tend to be newer and higher-quality buildings. 

What we see as well, are properties with a high value add upside will be valued for their potential, rather than the current state which compresses, or lowers, the Cap Rate. 

You are going to see higher Cap Rates in secondary and outlying markets. These are areas like the midwest west and some of the northeastern and southeastern markets. There are not much appreciation in these markets, however higher Cap Rates can result in higher short-term to midterm cashflows.  

When buying Commercial Real Estate you are sometimes presented with just the current year NOI and a cap rate with no price, and the valuation is up to you based on your assumption and evaluation of the property. Other times you will receive the price and NOI, and then find the Cap Rate. 

In Summary; 

• >Cap Rates are a foundation of Commercial Real Estate Valuation.
• >Core markets have the Lowest Cap Rates with the highest appreciation.
• >Secondary markets less stable markets have higher Cap Rates and can have higher Cashflow, but have a much higher risk. 
• >Cap Rates are a good guide to seeing where the demand is.
• >Cap rate = Net operating income / Current market value (sale price) of the asset. 
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Please contact me with any Real Estate questions at any time, I love to help!

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