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Cap Rate is short for capitalization rate. It's a common real estate term that is primarily used to derive the value of a commercial real estate asset. Let's take a look at its components.
1. Cap Rate = NOI / Value
R = I / V
2. Value = NOI / Cap Rate
V = I / R
3. NOI = Cap Rate * Value
I = R * V
First, we have r, which is the Cap Rate. We have I, which is the Net Operating Income. And we have V, which is the Value. Or, in the case of an acquisition, the purchase price.
The Cap Rate formula is quite simple. The Cap Rate is simply r equals I over V. That exact same formula is also translated into V equals I over r.
Imagine you have a property with a net operating income of $100,000, and the value of that property is $1,000,000. That gives us a Cap Rate of 10%.
If that same property with $100,000 of net income had a $2,000,000 purchase price, or value, it would have a Cap Rate of 5%.
Quite often the net operating income of the property that's being looked at is set. It's fairly fixed, and the Cap Rate is determined by either the purchase price that's paid for the asset or the value, perhaps, on appraisal.
What this tells us is that, if an investor is acting as the buyer, then they typically want a higher Cap Rate. They want to have to pay less money for the same net income, rather than more money. Buyers are typically looking for higher Cap Rates, or a higher un-leveraged return. Whereas sellers would typically want to find a lower Cap Rate.
Let's take a look that in reverse from the seller's perspective. Sellers of real estate, quite often, will look at the existing market Cap Rates in order to determine the value of their asset. Typically, that goes something like this.
Imagine that seller has an asset for sale and in the same area there are several other similar type assets that have sold recently. Let's say this one here sold for a six and a half cap. This one here sold for a seven cap. This one sold for a seven cap. And this one sold for a seven and a half cap. Perhaps this one was slightly superior, maybe in age or quality. These two are comparable. And perhaps maybe this one is a little bit inferior. The seller might be able to derive that their Cap Rate is about 7%. Using that same formula of v equals I over r, $100,000 divided by 7%, 1.428 million.
Now, perhaps the seller thinks, hey, my property is comparable to the one that had a lower Cap Rate and maybe they want to say, okay, we're going to take that $100,000 but I'm going to sell it a six and a half cap. And then when they would find that their property is worth $1,538,000.
The point there is that quite often, especially as a seller, the net operating income is relatively fixed and using existing market Cap Rates from recent comparable sales, the seller can plug that number in and determine what their estimated market value is.
Important to keep in mind is that investors don't typically buy just on Cap Rate. The Cap Rate does tell them what the unlevered performance of the property is, 7% return, 6.5% return. But after accounting for debt and leverage, the buyers are typically looking for cash on cash return, rather than Cap Rate.
Cap Rates do allow us to compare different properties from a yield perspective. However, they don't necessarily tell us what the net return to the investor will be as would cash on cash.
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