What Is A Cap Rate?
By Diane Bassett “Cap rate” stands for “capitalization rate” and when it comes to real estate you can think of it as a number that summarizes the relationship between a few important aspects of a property—it’s net operating income (see below for an explanation of this) and it’s price (or value). The cap rate of 7 represents an annual return (before mortgage payments and income taxes) of 7% on the total investment you made when you bought the property at the price you paid. We use it to figure out how much to pay for a particular property. If you want to make a certain annual return (again, before your mortgage payments and taxes), you make that your target cap rate and use it to determine the maximum you’d be willing to pay for a property. So a building might have a cap rate of 5, or 10, for example. We already talked about the gross rent multiplier in another article and you may remember that the GRM is a bit limited in that it doesn’t take the expenses of a property into account. Cap rate takes the expenses of a property into account so it’s a more thorough snapshot of a property than the GRM figure. “Net income” refers to the amount of money you have left over for the property when you’ve received the rent and you’ve also paid the operating expenses for that month (stuff like the landscaping fees, the utility bills, the property management fees). It is easy to understand that if you have just a little bit of rent but a whole lot of expenses you’ve got a problem. A big negative cash-flow. So getting a grip on the relationship between the net operating income (or NOI as I’ll call it now) and the price you paid (or are considering paying) for the property is important. The cap rate is calculated by taking the NOI (for some period of time—most of us use the first year) and dividing it by the price you paid for the building (or are considering paying). We then multiply that by 100 to make it a round number rather than a percentage. A higher cap rate is better than a lower cap rate if you are the one buying the building. The seller wants to sell to you at a higher price which creates a lower cap rate. So let’s give this a real world example. Let’s say you are considering buying an apartment building and you’re trying to figure out if this particular building is a good deal or not. Should you buy it? What would be a good price? What would be too much? We would do a number of things to answer this question but one of them would be that we would do some research with our Realtor, Diane, to find out what the cap rate is for similar properties in that area. The beauty of the cap rate figure is that it helps us evaluate one property relative to the other properties in the area. Let’s say the market cap rate for similar buildings is 8. So the lowest cap rate we would want to pay is 8 (remember, the higher the cap rate, the better). If the building you’re considering has a net operating income (NOI) of $523,000, you can figure out the maximum price you’d want to pay for that building and still achieve the desired cap rate of 8. Here’s the formula: (NOI / desired cap rate )x 100 = the price you would be willing to pay
So that would be (523000 / 8) x 100 = 6,537,500 . So the highest price you’d be willing to pay to obtain that property if you wanted to hold to a cap rate of 8 would be $6,537,500. Keep in mind that the cap rate doesn’t encompass ALL of your expenses on the building, just your operating expenses. It doesn’t take into account your mortgage payments (which is also called “debt service”). But it’s good for isolating the elements that are directly related to the property—the operating expenses and the price. The loan terms might vary from one loan to the next, so including the mortgage at this point would muddy the water. Next month we’ll look at the cash flow before taxes, which DOES take the mortgage payments into account. To recap, here are the formulas for the cap rate calculations we use most often: To figure out the cap rate for a particular building, (NOI / price of the building) x 100 = cap rate To figure out what the target price should be if you know you want your cap rate to be a certain amount: (NOI / desired cap rate) x 100 = target price for the building