If you listen to any conversation about commercial real estate (CRE) within a minute the subject of cap rates will come up. Those who are just beginning to explore CRE are often thrown off by what one is and how it is calculated. A cap rate is really a simple thing that is often made overly complicated by the way it is explained. Let’s walk through what a cap rate is and then we’ll look at how they are used so that the next time the conversation turns to CRE you’ll be right there in sixty seconds when they get to cap rates.
A Capitalization Rate or Cap Rate for short is simply what you would earn on a property if you bought it for all cash. That’s it, nothing more, nothing less.
Property Price X Cap Rate% = Earnings (Annual).
Or to put some numbers on it:
$5,000,000 X 7% = $350,000
Pretty simple right? It is important to remember that these earnings (called Net Operating Income or NOI) are based on having no debt on the property because NOI is just like EBITDA, Earnings Before Interest, Taxes, Depreciation and Amortization. The reason for this is because there are so many ways to finance a property, from all cash to 75% loan to value (LTV) or higher. A cap rate is used to measure the results of the property itself, not the financing package it is wrapped in. To measure the results after debt payments another measure called Cash-on-Cash Return is used. Cash on Cash Return is similar to the dividend yield on a stock, but that’s a subject for another post.
Cap Rates are pretty handy things which is why they come up in conversations about CRE all the time. Most often they are used to compare the prices of different properties, even properties of different sizes. Cap rates are also used to describe the pricing of buildings in a particular market. You will hear it said that apartment cap rates in the Seattle market are at X% or in the range of Y-Z%. Knowing what the expected cap rate is in a market can give you a idea of what any particular building should be earning (again, on an all cash basis). If you are looking at a building that’s priced at $5,000,000 and know that cap rates are around 7% you would expect that the NOI on that building to be about $350,000.
With a little algebra you can use a cap rate to figure the price you want to offer for a building based on its actual NOI.
NOI ÷ Cap Rate% = Price
Let’s say you find a building with an NOI of $425,000 and believe that cap rates for that type of building should be 8%.
$425,000 ÷ 8% = $5,312,500
Cap Rate is the common way to answer the question how much is that property worth? In that way it is similar to a stock’s earnings multiple, a way of determining value. In my next post I’ll run through how to convert a cap rate to an earnings multiple so that you can get a feel of how a property investment would compare to one in a stock.
Meanwhile just remember that Price X Cap Rate% =NOI and you can be part of the next CRE conversation you find yourself in…. or at least be able to nod along sagely!