The capitalization rate, or cap rate, is the required or expected rate of return on a property. It can be calculated as is a property’s annual net operating income (NOI) divided by its current value:
Cap Rate = NOI / Current Value
For a new or renovated property, it can be extrapolated from comparable properties in the same neighborhood, adjusted for unique features, such as the property’s façade or the quality of its tenants. Usually, the estimated cap rate is within a half percentage point of the average for local comparable properties.
The Gordon Modelis another way to estimate cap rate, where you subtract a constant growth rate, g, for NOI from an investor’s required rate of return, known as the discount rate d:
Cap Rate = d – g
For example, suppose you are evaluating a building with an NOI of $100K that is growing at a constant rate of 1 percent annually. If an investor has a required rate of return of 10 percent, the cap rate would equal (10% – 1%), or 9 percent. This only works when the growth rate is less than the discount rate.
Evaluating a Property
Whether you plan to use a property to generate rental income, operate your business out of it, or fix and flip it, knowing the appropriate amount to pay can make the difference between a winning and losing transaction.
The cap rate is used in the income approachto valuing a property, using the equation:
Current Value = NOI / Cap Rate
For example, suppose a rental property has a cap rate of 8 percent and an annual NOI of $700,000. The current value is ($700,000/.08), or $8.75 million.
It’s very useful to have a dispassionate estimate of a property’s value when it goes up for sale, as both buyers and sellers will have a good idea of how much to offer/ask. It’s also used by lenders when figuring how much to lend. Note that hard money lenders use the estimated value of a property as it would exist after rehabilitation to help calculate the amount they will lend.
The income approach can be adjusted for recent sales, but it doesn’t account for factors such as required repairs, collection loss and vacancy rate, which can lead to overstated value and NOI.
If a property has a complex, irregular income stream with significant variations in cash flow, the income approach can easily give an erroneous valuation. In that case, you can use different valuation methods, such as discounted cash flow analysis or the band of investment method.
Other Uses for Cap Rate
The cap rate can also be used to compare the returns on rental property investments. All other things being equal (which, in truth, they seldom are), you might prefer to invest in a property with a higher cap rate than an alternative with a lower cap rate. However, a high cap rate can mean a property is riskier, in that it might be more vulnerable to factors that can hurt its cap rate. Therefore, the cap rate should be tempered by factors such as:
- Property age
- Tenant diversity and creditworthiness
- Tenor of leases already in place
- Regional economic fundamentals, including demand and supply of similar properties.
Cap rate trends over a several-year period can give you a good idea where a market is headed. For example, compressing cap rates indicate a market that is heating up, because values are being bid higher.