What is a Cap Rate?

Investing in real estate? You need to know cap rates.

Commercial Real Estate, more-so than other businesses, is littered with industry jargon. Brokers and investors use these terms so often that they can forget that business owners aren’t familiar with their language, which can lead to a communication breakdown during discussions. If you’re looking at purchasing a commercial property, chances are you’ve seen buildings offered at an “8% Cap” or “10% Cap.” That sounds fancy, but what is a cap rate?

A cap rate is the ratio of the Net Operating Income (NOI) to the property asset value, and is used to identify the return an investor can expect to receive from an investment property. Unlike residential real estate, which is based on the price per square foot of nearby comparable properties, the value of commercial real estate is determined by the amount of return an investor can expect to receive. Cap rates are determined by the market and will fluctuate depending on interest rates, available product, and the class of the property.

For example, if an office building is listed at $1,000,000 with a 10% cap rate, that means that the annual NOI is $100,000. To find the value of a property, we divide the NOI of $100,000 by the 10% cap rate (100,000/.1), which brings you to $1,000,000. Cap rates are reversely proportional to value, so a lower cap rate yields a higher valuation. Using this same example, a property with a $100,000 NOI at a 5% cap rate would be valued at $2,000,000.

Net on Investment / Property Value = Cap Rate            100,000 / 1,000,000 = 10% Net on Investment / Cap Rate = Property Value         $100,000 / 10% = $1,000,000 Property Value x Cap Rate = Net on Investment       $1,000,000 x 10% = $100,000

Now that we know what a cap rate is, why use it? Cap rates give investors a quick glance at the investment opportunity presented by a property. If the investment is offered at a 10% cap, you can expect to yield a 10% return; an 8% cap would yield an 8% return (both assuming you paid cash without financing). Investors choose to invest in different cap rates depending on their risk tolerance. Lower cap rates tend to denote a stabilized property in a proven market, whereas higher cap rates may mean the property has vacancy, maintenance, or desirability issues – but more potential for upside.

Have anymore questions on other common commercial real estate terms? Check out a short list on commonly used lingo here.