When evaluating properties, brokers and investors often talk about the cap rate of an asset. Indeed, the cap rate is a fundamental tool in the commercial real estate (CRE) space. With its simple formula, one can see why so many investors and professionals rely on the cap rate to provide a clean and easy way to determine the value of an asset. With every tool, however, there are limitations and misuses. Understanding exactly what a cap rate is, as well as what its constraints are, can help us become better CRE investors. 

What is a cap rate?

The capitalization rate, or cap rate, is essentially a metric to measure a property’s unleveraged performance or return. In simpler terms, the cap rate is the annual net operating income or NOI  (gross income minus expenses) divided by the value of the asset (sale or purchase price):  

Let’s say we are evaluating a $5 Million apartment building with 35 units, generating $300,000 in NOI annually. The cap rate would be:

Expressed as a percentage, this means that the cap rate for this asset is 6%. Because we analyze the cap rate essentially as a fraction, the higher the numerator (NOI) versus the denominator (asset value or price), the higher the cap rate percentage. The opposite is also true: as the property value or price increases while the NOI stays the same, the cap rate decreases.

What can the cap rate tell us?

‍Since the cap rate equation can be reversed to calculate a property’s value, many investors rely upon this metric when quickly determining a suitable offering price on a new acquisition. Similarly, brokers use the cap rate to attract buyers by demonstrating transparency in the pricing of an asset. The cap rate allows us to compare the value of one property against another with similar characteristics, such as asset type, class, condition, and location. Essentially, all other factors being equal, how does this property’s price compare against those sold in recent months?  

As is in any other investment, the return is a reflection of the level of risk and quality of the investment. A higher cap rate usually means there’s a greater margin for profitability, but greater risks involved (i.e. less desirable neighborhood and/or market, lower asset quality that requires more renovations, etc.). A lower cap rate usually indicates that there is a tighter margin for returns, but the acquisition target’s value is greater and with lower risk (i.e. more desirable location, better maintained, more up-to-date, etc.). The cap rate can also serve as a general market indicator where a higher cap rate trend can point to a softer, less competitive market, while a tighter or lower cap rate means a more competitive market where buyers are willing to pay more.

This quick valuation method is also helpful when evaluating refinancing options. A potential loan amount can be calculated based on the estimated value and the lender’s loan-to-value (LTV) metric. This will help assess if the refinance is possible and/or beneficial.  

What does the cap rate not tell us?

Notice that the cap rate does not take into account mortgage/financing, thus giving an investor a snapshot of the unleveraged performance or return of the asset. The cost of funds is an important component of the overall profitability of a deal and must be reviewed outside of the cap rate formula. Another detail worth noting is that the cap rate analyzes current NOI against the value of the asset at that particular time. Thus, the cap rate is a snapshot of the property’s performance or return at one given moment in time. Like a blood pressure reading on a patient, the cap rate is just one data point in evaluating the health of an offering. 

We touched upon the ability to reverse the cap rate formula to come to an estimated offering price when making an offer on a new acquisition. This method is reliant on a steady market.  It is therefore crucial to be aware of overall market trends. If property values are going up, cap rates calculated based on historical sales may land us with an offering price that is below other competitive offers. When markets are softer, with more available inventory and fewer buyers, using the cap rate calculation alone may have us overpaying for an asset.    

In short, to price an asset competitively, the cap rate needs to be considered in conjunction with other market indicators and moved up or down accordingly. While the cap rate is a great back-of- the-envelope calculation to get an overall picture of a deal at a given moment in time, it is merely an overview of an asset’s return. More in depth analysis will reveal if the acquisition makes sense with current market conditions and all factors considered.

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