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WHAT IS CAP RATE?

A property’s capitalization rate, or “cap rate”, is a commercial real estate asset’s return. The cap rate is determined by taking the property’s net operating income (NOI) and dividing it by the value of the asset. Commercial real estate is an investment type, so the return is a reflection of the risk and the quality of the investment. The cap rate does not take into consideration a mortgage, if any, and is most useful in a market where sales occur often and buyers can use comparable sales of stabilized assets to compare and determine if the price being offered is reasonable, relative to other sales.

Using an asset’s cap rate may be helpful when looking to value an asset at purchase and to compare that asset to the sales of other similar assets in the market.  For example, a buyer is looking at an apartment building that has 10 units each earning $2000 a month in rent; this means the property is grossing $20,000 a month or $240,000 in income a year. The buyer then subtracts the property’s expenses, which are $96,000, and the result is a net operating income (NOI) of $144,000. If the buyer knows the market is a “7 cap market” (i.e., a 7% capitalization rate), the buyer can divide the $144,000 by 7% and determine that a reasonable purchase price to offer the seller is $2,057,143.  Flip this around, and if the seller is marketing the property for a $2,060,000 sale price, and the buyer requests and receives a 12 month trailing profit and loss statement that shows $144,000 in net operating income, the buyer can determine that the asset is being sold at a 7 cap rate ($144,000 / $2,060,000) and compare it to other similar properties to determine if the sale price is reasonable.

What does the Cap Rate mean?

The cap rate is an asset’s unlevered (no mortgage) return, and a reflection of an asset’s relative value.  If the buyer were to purchase the property all cash in the example above, and if the property distributes the same net operating income, the buyer would receive a 7% return on their investment.  Cap rates are seen as a measure of risk and return, a “low” cap rate of 3-5% would mean the asset is lower risk and higher value; a “higher” cap rate of 8-10% reflects a lower price, higher risk and higher return.⁶

How is the Cap Rate used? 

The cap rate is a metric that a buyer can use to compare the price of an asset in the market with other similar properties that have recently sold and for tracking trends in the market. Buyers can use the cap rate as a way to determine if they are getting a deal on a property by comparing it to the prior sales prices of other similar properties. Brokers and sellers use cap rates as a tool to attract buyers to the asset by showing transparently how they priced the asset, providing an asset’s potential yield. 

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Are Cap Rates only used when looking at the purchase price of an asset?

Cap rates can also be used to quickly estimate a property’s value when considering a refinance. If a property owner wants to consider a refinance, they may need an estimated value to determine what potential loan amount the property supports using the lender’s loan to value (LTV) metric. Once the estimated value is calculated, the owner can determine whether a refinance is possible, or even worth it.

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Are there any other ways to use Cap Rates?

A financial “model” can be put together to determine a project’s projected return profile and to see if it meets the buyer’s return targets. The model uses the purchase price, closing costs, the senior debt, projected income and expenses with growth over the anticipated hold period, as well as a projected exit price and potential profit. In order for a buyer to complete the data inputs in a model and reach a projected internal rate of return (IRR), many other figures must be assumed using available market data.  This can be overwhelming for real estate owners, which is why The Liquidity Source is dedicated to providing transparency when it comes to real estate financing.

While Cap Rates are a useful metric, they should not be relied upon solely when analyzing an investment property. If you are looking for free advice about your commercial real estate, it may be time to reach out to The Liquidity Source. Our trusted advisors are available to answer any questions you may have.

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