The Meaning and Power of Cap Rate

There are many ways to determine value in commercial real estate. One of the most popular for investment properties is the cap rate.

Cap Rate Definition

What is a cap rate? The capitalization rate, most often shortened to cap rate, is a ratio of Net Operating Income (NOI) to property value or total purchase price. NOI equals all revenue from the property minus operating expenses. NOI is calculated before tax that excludes debt service, capital expenditures, depreciation, and amortization.

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Cap Rate Example

Suppose we are examining a possible investment property. With any two pieces of the equation, we can calculate the remaining part. For our example, we can assume that the property has an NOI of $100,000. Similar properties have sold at a 7.0% cap rate. The value of this property would be approximately $1,430,000.

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What is Cap Rate REALLY Telling You?

One way to intuitively think about cap rate is that it represents the return an investor would earn on an all cash purchase. From the example above, the cash investment of 1,430,000 would produce an annual return of 7.0%. The cap rate and valuation are inversely related. As the cap rate rise, the valuation multiple would decrease.

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When not to use Cap Rate

Cap rate should not be used when there is a complex or irregular set of cash flows for the property. In that case, it would be much more appropriate to do a Discounted Cash Flow (DCF) calculation. The cap rate calculation holds up when the proforma for the building is an accurate estimate.

Making Cap Rate Work For You

Understanding cap rate is critical to understanding the values that an investor is willing to pay for an income producing asset. If you are purchasing a building as an owner/user it is also important to understand that if a building currently has no income, it will be valued more likely on a price Per Square Foot (PSF). Once you, as the new owner, establish a lease for your business entity (tenant). You are changing the valuation methodology to a cap rate calculation. With this understanding, it is possible to:

  • Purchase a building

  • Write yourself a favorable long term lease

  • Sell the building to an investor on a cap rate

  • Retain the equity (the difference between the PSF purchase price and the cap rate sale) that you have earned by creating an income producing property

It is reasonable to question the logic of selling a building almost immediately after purchase, however as you can see, the asset that you are selling is very different than the asset that you purchased.

An executive with more than twenty years of experience in leadership, management, strategy and project development. Over 10 years as a military fighter pilot, serving as flight lead and flight commander. Three combat deployments to both Iraq and Afghanistan with 1st Ranger Battalion as Air Liaison Officer.

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