What is Cap Rate Really and What Does it Mean for Investors?

What is Cap Rate Really and What Does it Mean for Investors?

What is the “Cap Rate”???

Investors hear the term “cap rate” all the time, the term is discussed by everyone in commercial real estate: buyers, sellers, lenders, appraisers, accountants, and brokers.  It is surprising how misunderstood “cap rate” is, and how few investors actually know what it means, how to calculate, and most importantly: what it tells you about an investment opportunity.  Here are three ways to understand what the cap rate or capitalization rate means:

1.  Overall Rate of Return:  Pretend you are buying a property with all cash.  In this case, the rate of return the building produces on your purchase is the cap rate.  For example, if an investor purchases a $1,000,000 property with all cash, and the building produces a $70,000 Net Operating Income, the cap rate in this instance is 7%.  Most purchases are not with cash, so the cap rate on those purchases is a blend of the buyer's return and the bank's return.

2.  How to Calculate:  The formula for cap rate is easy, understanding what it means is more complicated.  The formula:

Cap rate =   Net Operating Income/Price

Think of cap rate as a snapshot in time on the overall return the building produces at this moment with current rents and typical expenses.  Buyers typically want to purchase at a high return, and sellers want to sell at a lower return for a higher price.  There is no “right or wrong” cap rate, as it is simply one factor in the value of a property.

3.  What is REALLY important to know about cap rates?  Since the formula for value is:

Value =  NOI/Cap rate

the cap rate has a TREMENDOUS effect on value and it is tied to interest rates.  When cap rates increase by 1%, the results are a staggering 10-12% short term reduction in value.  What does this mean?  We have a unique window in history where the cap rates and interest rates are beneficial to both buyers and sellers.  Buyers are able to lock in long term rates, and sellers are able to sell with low cap rates and still provide value to buyers.

A couple of items to consider:

-Do not confuse cap rate with cash on cash return, the cash return is the return for the buyer on their down payment, the cap rate is the building's overall return.

-Be careful in overvaluing cap rate in your valuation analysis:  there are 11% cap rate properties that are horrible investments and 4% cap rates that are fantastic opportunities.

-Cap rates in the Portland metro are are hovering just below 7% and historically have been from 7-9% over the past 20+ years.

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