The capitalization rate or "cap rate" is a concept that is fundamental to the commercial real estate industry. It is however commonly misused or misunderstood. This post should help clear the term up a bit and allow you to understand how to properly use it.
Definition of Cap Rate
The capitalization rate is the ratio between NOI (Net operating income) to property asset value. An example of this would be if a property was listed on the market for $2,000,000 and generated a NOI of $200,000, this would mean that the capitalization rate would be $100k/$1million, or 10%.
Cap Rate = annual net operating income / cost or (value of the property)
Example of Cap Rate
Let's suppose that we were researching the sale of a commercial strip center with a net operating income of $450,000 and a sale price of $5,000,000. In the commercial real estate business it would be common to say that the property is being sold at a 9% cap rate.
Logic behind the Cap Rate
The logic and intuition behind using this ratio is to be able to find a percentage return to the investor on a all cash purchase. So, on the example above the investment in that particular property would yield a 9% annual return to the investor.
When to use Cap Rate and when not to use it
The cap rate is a highly common and useful ratio in the commercial real estate sector, and is very helpful various situations. It is very useful when making a quick decision on whether a property investment represents a better value or lower risk when comparing it to other on the market. For example, a 7% cap rate acquisition compared to a 10% cap rate for a similar property in a comparable area should immediately help the investor indicate which property has a higher risk premium over the other.
Another useful way cap rates can come into play is when they form trends. If you look at cap rate trends in a particular market then it can give an investor an indication as to where the market is headed and if it's an opportune time to invest. Depending on whether the cap rate percentages are rising or falling in a uniform manner that can be shown by the trend, one can make certain assumptions as to the direction of valuations.
Cap rates can be incredibly useful for quick calculations and value comparisons, but there are certain times where they should not be used. For example, if a property's NOI is unstable of irregularly complex, with large fluctutations in cash flow, a more in-depth discounted cash flow analysis will serve to better reveal a proper valuation.
Essence of the Cap Rate
One way to conceptualize the essence of cap rate is to think about the risk free rate of return that one might get from ironclad or very secure investments like treasury bonds, and subtract that rate from the cap rate to calculate a risk premium. For example, let's suppose a treasury bond yields a risk free premium of 3% annually. Then let's say the acquisition cap rate of a certain property is 6%. This would yield a risk premium on the property of 3%, which reflects the entirety of risk the investor would assume over and above the risk free treasury bonds. This calculation does not take into account many important factors such as the age and integrity of the property, the reliability of the tenants, length of current leases of tenants, or any underlining economic factors of growth or recession.
After considering the aforementioned factors on a certain property, it's then quite easy to see the relationship between risk free rate of return and the overall cap rate. The ultimate risk factor of the property, which is a somewhat subjective combination of the risk premium plus any knowledge gained about the current property functionality will determine if the investment is worth making. In other words, cap rate is a useful formula in helping the investor narrow down risk factors, but the ultimate decision lies with the judgement and experience of the investor and how much risk they deem is worth the return.