What is a CAP Rate?

Jeffrey and his wife Michelle were very anxious about their sinking stock portfolio so they decided that they would sell some stock and invest some of the proceeds in commercial real estate. Neither Jeffrey nor his wife had ever owned commercial real estate before, so they began to educate themselves by looking on line at the various types of investment properties. It seemed that every investment property was being marketed with a quoted cap rate. Some properties had cap rates as low as 6% and others had cap rates as high at 12 percent. Jeffrey called me and asked me what a cap rate was and whether it was better to buy a building with a lower cap rate or a higher cap rate.

Although commercial appraisers will sometimes use a much more sophisticated method of calculating a cap rate, the simple version is widely used by the typical investor and by commercial real estate brokers. The cap rate (short for capitalization rate) is a method of comparing the return of different types of real estate investments at any point in time. The cap rate is calculated by dividing the net operating income (NOI) of any investment property by the expected sale price. The net operating income is determined by subtracting the property operating expenses from the gross income for the property. Basically, add up all the income and subtract all the operating expenses in any one year and you will have the net operating income. Now divide the net operating income by the sales price and you obtain the cap rate.

Example: An office building has two tenants paying a total of $60,000 in rent for the upcoming year. If the building expenses are expected to be $20,000 per year, then the NOI is $40,000 ($60,000 - $20,000). If the sale price is $400,000, then the cap rate is 10 percent ($40,000/$400,000). If the NOI was only $20,000, then the cap rate would be 5 percent. Since every investor would prefer earning $40,000 versus $20,000 of NOI, a higher cap rate is more desirable.

It is very important to understand that the simple cap rate is only one indicator of how the property is performing at a given moment. It does not take into consideration market conditions, lease terms, condition of the property, location of the property, local competition or financing terms. If the property income is expected to rise or fall sharply in the near future due to rent increases or lease expiration, then a cap rate that is higher or lower than typical may be appropriate. The cap rate is only a first look indicator of whether a property is approaching your personal investment criteria. In the current market, one of my investors won’t even consider looking into a property unless the cap rate is above 9.0 percent. If the cap rate is at least 9.0 percent, he will look into the property in more detail.