How do you pick and use a Cap Rate?

With over 40 years’ experience in the real estate investment industry, I find that Cap Rate (Capitalization Rate) is perhaps the most misunderstood concept in the business.  Many of the examples and definitions of Cap Rate that I have seen are wrong, although based on the same mathematic formula used in this essay.  Many define Cap Rate as being the NOI (Net Operating Income) divided by the building value.

NOI ÷ Building Value = Cap Rate

That is incorrect, as that formula is a determinant of one kind of Return on Investment, not of Cap Rate.

So, if this calculation is incorrect, what is Cap Rate?  How is it used?  And, most importantly, how do you pick a Cap Rate?

The Cap Rate is a factor used to determine the value of an income property when you know the true Net Operating Income (NOI) of that property.  It is a unit of measurement used to compare one building against another.   For a given income, the lower the Cap Rate, the higher the building value. OR, the lower the NOI, the lower the value if using the same Cap Rate.  You cannot determine the value of an income property without first having a Cap Rate, at least now using the Capitalization Method.

There is no one Cap Rate that will work for all properties, in all cities, in all market conditions.  It varies from city to city, and even neighbourhood to neighbourhood, from property type to property type, and from time to time.  Determining the prevailing Cap Rate can be a challenge.

For a beginning investor, one way would be to ask a qualified real estate appraiser what he/she would use as the Cap Rate for a specific type of building in the area being considered.  The appraiser should be able to give that off the top of his/her head.  But, that answer comes from market knowledge and calculation of previous sales.

The appraiser keeps records of all known sales in a given area.  Let’s assume we are analyzing a 20 unit apartment building and the average Return on Investment at this time for buildings of a similar size, condition, and area is 8.5%.  One can assume the prevailing Cap Rate is, therefore, .085.  Note the way the number is expressed.  It is not expressed as 8.5%.  Also note the qualifications of: time, size, condition, and location.  A building on a busy street would have a different Cap Rate, probably higher, with all other things being equal, than a building three blocks away abutting a city park.

When looking for a property, and during the due diligence phase, the investor should begin to accumulate data that will include asking price, and income and expenses statements.  The investor can enter all that data on a spreadsheet and calculate Returns on Investment for all of the investigated buildings, thereby creating his/her own source of comparable ROI’s.  (Setting up accurate expense statements is another topic altogether.)  Assuming the resulting average ROI’s are approximately 8.5%, one can then use that figure, expressed as .085, as the prevailing Cap Rate.  This is the same information that appraiser would give you, but collected in house.

There is another way to build a Cap Rate.  It is called a Derived Capitalization Rate, and is comprised of two parts: 

·         The Financing Cap Rate

·         The Equity Cap Rate

Assuming your lender will give you a 75% loan to value mortgage at an interest rate of 5%, this is the formula for calculating the Financing Cap Rate:

LVR * Interest Rate = FCR
.75 * .05 = 0.0375

Next we calculate the Equity Cap Rate, using a similar formula.  For this scenario, it is assumed the investor wants an 8% ROI on his/her 25% equity investment.

Equity Ratio * Investor’s Expected Rate of Return on Investment = ECP
.25 * .08 = 0.020

Those two numbers are then added together to set the Cap Rate.

FCP + ECP = Cap Rate
0.0375 + 0.040 = 0.0575

The Cap Rate for this investor, therefore, would be .058.  Cap Rates are generally round off to two or three digits.

We can now use our Cap Rate to help establish a building value.  Using the above example, assume the NOI is $58,000, we use this formula to determine Market Value to the Investor:

MV = NOI ÷ Cap Rate
MV = $58,000 ÷ .058 = $1,000,000

If another Investor used a Cap Rate of .065, he/she would be willing to pay less for the same property.

$58,000 ÷ .065 = $892,300

It should be pointed out that neither answer is wrong.  It is just that the second investor expects a higher ROI than the first.

Most commercial REALTORS© know what the prevailing Cap Rate for a given property type is and list the property for sale using that Cap Rate.  However, sellers only set the asking price.  Buyers set the selling price, and will, more often than not, use their own Cap Rate to determine their offer price.

When comparing one building against another, investors most often compare ROI’s.  There are almost as many ways to calculate ROI as there are investors, (Internal Rate of Return, Modified Internal Rate of Return, Yield on Asking Price, Cash on Cash Return, Before Tax, After Tax, etc.) and also subject of another discussion.  What is important here is that all who rely on the ROI for decision making understand which method is being used, so that apples are being compared to apples.