Cap Rates – Defined and Explained Understanding the most thrown around term in Commercial Real Estate

On November 1, 2004, I was honorably discharged from the Marine Corps and drove home to Kentucky. The next day, I started my career with my dad in the family business of commercial real estate. I knew nothing about the industry and did not have a license. 

I remember the biggest learning curve for me was picking up the jargon of commercial real estate. I would have a conversation with a prospect or sit in on a meeting, and I would write down all these terms that I did not understand like Cap Rates, ROI, IRR, cash on cash return, GRM, NOI, TVM and many others. Then I would go to my dad’s office later and ask him to explain them to me. 

Not everyone has a dad in the business who is available to them like mine was to me. In this series of posts, I am going to explain these terms so the new commercial real estate investor can quickly understand the jargon and begin to make wise decisions. 

Cap Rates

Capitalization rate or direct capitalization is a method quantifying the relationship between income and value of an income-producing piece of real estate. That’s all it is. It is NOT the return you will get if you buy the property. Let’s consider how to calculate it and then how to use it. 

The formula for calculating a Cap Rate is Net Operating Income (NOI) divided by the value of the property – (NOI/Value = Cap Rate). The NOI is simply the property’s income less the expenses.  

For example, if I buy a piece of property for $2,000,000 and the NOI is $160,000, the Cap Rate would be 8%. 

$160,000/$2,000,000 = 8% 

Earlier this week, I met with a client and his wife who are selling some residential rental property so that they can invest in commercial real estate. He is willing to buy commercial property up to $5 million at a 7% Cap Rate. What is he saying? He is saying that he is willing to pay up to $5 million so that his annual income from the property is $350,000. (NOI = Value x Cap Rate or $350,000 = $5,000,000 x 7%). 

Here are some things to understand when using a Cap Rate: 

  1. The Cap Rate is a snapshot in time – The Cap Rate measures an asset at a particular point in time – generally over the course of a year. I recently bought a strip center with a group of investors. Our Cap Rate on the purchase was 7.57%. That means when you divide the previous year’s NOI by the amount we paid, the Cap Rate came out to 7.57%. If you wanted to project next year’s NOI and divide it by the value of the property, you could then project next year’s Cap Rate. 
  1. The Cap Rate measures risk – You’ve heard of the risk/reward relationship, and the Cap Rate is a measure of this relationship. The lower the Cap Rate, the higher the value for the same income. Or in other words, the lower the Cap Rate, the lower the perceived risk of owning that property. Thus, the price is higher, and the return is lower. If my client was willing to buy a $5 million property at a 9% Cap Rate, he is saying that he is willing to take more risk and wants a higher return while he owns it. To put it another way, if you buy a 20-year leased, corporate-guaranteed Walgreens in San Fransisco (so incredibly low risk of Walgreens not paying their rent), you should expect an incredibly low Cap Rate and an incredibly high price. 
  1. The Cap Rate is the unleveraged return of the property for one year – If you were to buy a property with all cash and no debt, the return on your investment would be equal to the Cap Rate (ignoring depreciation). It also does NOT factor in growth.
  1. Cap Rates are normally used in relation to income producing properties – Remember the formula for a Cap Rate: NOI (income)/Value of the property = Cap Rate. If the value of the property is zero because it produces no rent/income, then the CAP Rate is an irrelevant metric. 

If you would like help understanding the value of your property based on an appropriate market Cap Rate, please reach out to us. Or, if you want help better understanding Cap Rates so that you can begin investing in commercial real estate, we’d love to talk to you. Please click below to schedule a time to connect with us.