What is a Cap Rate?

In commercial real estate, a property’s capitalization rate, or "cap rate" is used by investors to understand the relationship between the price or value of the property and the net operating income it produces. It's a mere rule of thumb used by investors to compare different real estate investments, much the same way the price/earning (P/E) ratio is used to compare stocks.

Cap rates are one of many tools used in real investing, but they don’t provide a complete picture of a particular property. In this post, I hope to provide a basic understanding of how they're used, and situations where investors need to be careful.

The formula for calculating a cap rate is:

Net Operating Income (NOI) divided by Price

Let’s take a look at an example.

Ivan the Investor acquired a property for \$1 million.

During the twelve months before the acquisition, the property produced Net Operating Income (NOI) of \$65,000. This means the historical cap rate is 6.5% (\$65,000 / \$1,000,000).

Pretty straightforward, right? Let’s dig a little deeper.

During the twelve months after the acquisition, Ivan’s new property is expected to generate Net Operating Income of \$80,000. This means the pro forma cap rate is 8.0% (\$80,000 / \$1,000,000).

Is the cap rate of the property Ivan purchased 6.5% or 8.0%? It’s both, which brings up the first place to be careful—they can be backward or forward looking.

Using Cap Rates

 Property A Property B Purchase Price \$1.1 million \$1.0 million Square Feet 20,000 10,000 Price / SF \$55 \$100 Location Rating GOOD, close to where Ivan lives, in neighborhood he’s very familiar with. GOOD, but 25 miles away from where Ivan lives, in a similar, but unfamiliar neighborhood.

At first glance, it seems obvious to Ivan that Property A is a better investment than B. After all, Property A is slightly more expensive, but also twice the size of B (20,000 square feet versus 10,000 square feet). As a result, Property A will cost \$55 per square foot, while B is twice that, at a price of \$125 per square foot.

Despite his instinct, Ivan performs additional analysis by first computing the NOI of both properties. Property A is expected to generate \$55,000 in NOI next year while B is expected to produce \$65,000. With the expected NOI for both properties, Ivan calculates the respective pro forma cap rates. Property A has a cap rate of 5% (\$50,000/\$1,100,000) and Property B has a cap rate of 6.5% (\$65,000/\$1,000,000).

So which property should Ivan choose? Property A with a lower price of \$55 per square foot, but a cap rate of 5%; or Property B, which will cost \$125 per square foot, but has the higher cap rate of 6.5%?

Before we get to Ivan's final decision, here's a tip from InvestFourMore blogger Mark Ferguson on how a cap rate can provide some insight on investment properties in markets outside your zip code: "The cap rate can give you an idea of the returns in [an] area." Ferguson points out in his post on cap rates and NOI that rates in the US can be anywhere between 5% to 15%. Calculating cap rates for investments in other geographies can give you some insight (albeit a rough one) on the type of return you can expect.

Let's get back to Ivan. As you may have guessed from the first example, Ivan purchased Property B. Why? Only Ivan can answer that question. I don't say that to be flippant, but to illustrate a point: cap rates are just one of many inputs that real estate investors use to evaluate properties. Price per square foot, for example, is another input.

With the information presented, it’s impossible to determine why Ivan chose Property B. Assuming that Ivan is a diligent real estate investor, he based his decision on a combination of each property’s relative risk, location, condition, age, and many other factors...that only Ivan knows.