What is a cap rate and why are they important ?

92 Replies

Cap Rate, or Capitalization Rate, is the expected return on a commercial real estate asset if there were no debt on the property. For example, a property that was purchased for $1 million with no debt, produces Gross Revenue of $200,000 per year, the annual expenses are $100,000, leaving an annual Net Operating Income of $100,000 (Gross Revenue - Expenses). Divide the NOI, $100,000, by the purchase price, $1 million, and you get a Cap Rate of 10% (NOI / Purchase Price). Meaning you can expect a 10% return on your investment of $1 million.

Cap Rate can also be looked at as a function of risk. Investors expect a higher return for investments that are riskier in nature. If you purchase that same property above for $800,000 and it produces the same NOI, it's Cap Rate is now 12.5%. That might sound better, higher return is always better, right? Not necessarily. The purchase price might have come down because the market views the property as over priced.

Cap Rates are often effected by the interest rates. As interests fall, Cap Rates often fall as well, because investors are able to borrow money at low rates, because it theoretically lowers their risk. As interest rates rise, Cap Rates often rise as well.

The power of the Cap Rate can be seen when you start to discuss value-add opportunities. 

For example:

Let's say I purchase that property for $1 million dollars at a 10% cap rate. Through a mixture of increased revenue and lowering expenses, I increase the NOI to $125,000 annually. Divide that new NOI by that 10% Cap Rate and that $1 million property is now worth $1.25 million. Not only did I increase the potential cash flow by $25,000 annually, I increased the value by $250,000. Now, if doing all of the above also made the asset seem less risky to other investors, they might think it's more of an 8 Cap now (8% Cap Rate). In that case, the property is now worth $1,562,000.

It cuts both ways though, let's say all of the above is true, but we have a sudden rise in interest rates that pushes the market Cap Rate to 12%. Now, that property, while we have increased the NOI by $25,000, is only worth $1,041,666.

There really is no way to determine what a "good" Cap Rate is because it depends on the investor's business plan, their goals, and their risk tolerance. 

In self-storage, an A Class facility in a Primary Market (think multi-story, full climate controlled, in a city like Phoenix) might be considered a 5 cap. While a C Class facility in a Tertiary Market (think single-story, over 20 years old, gravel driveway, in smaller town), might be considered a 10 cap.

Again, it's largely a function of risk. Typically, the higher the Cap Rate, the higher the risk, but the higher the potential return.

Personally, I like to look for a Cap Rate that is at least 2% higher than the interest rate at which I am able to borrow, with a significant value-add opportunity.

"What is a cap rate and why re they important?"

CapRate = Net operating income / Sales price

Why are they important?  Most people accept they are an accurate representation of value.

I kinda think they are BS:

1) They're reported.  Depends on who gives them - Owners, brokers, appraisers, buyers.  So reporting bias.

2) What numbers are they based on?  Actuals or, god forbid, pro forma

3) They don't account for futures.  If a diamond is at peak performance and low caprate is it worth more/less than something with upside at a higher CapRate?

4) They don't account for the cost of money which affects CFBT.

@Isacc Lightbourn " The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market."

If you are n residential, don't worry about it, if you're jumping into commercial, read a book about it!

A simple google search of "cap rate" would result in a variety of definitions. On the one hand cap rate is defined as some type of measure of return while on the other hand it is defined as a measure of value. These polar opposites of cap rate definitions can be illustrated below:

From Investopedia (https://www.investopedia.com/t...). This definition is also quoted by another poster.

The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market.


From Wikipedia (https://en.wikipedia.org/wiki/...)

Capitalization rate (or "cap rate") is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.

I'm with the Wikipedia definition in that Capitalization Rate is a valuation measure. Cap rate is a rate at which a certain type of income (i.e. in this case NOI -> Why do we pick NOI? This deserves another post!) is capitalized into value. An easier way to look at this, cap rate is a rate that converts a dollar of NOI into x dollars of VALUE. That's all cap rate does! For a lack of better word, it is really a conversion rate! It converts NOI into VALUE (much the same way a money changer converts US Dollars to Mexican Pesos at the southern border). Wikipedia has several examples of the use of cap rate as a valuation measure.

I don't think cap rate was ever designed to measure performance. Many businesses use a variant of cap rate (the "income" approach valuation) to value the business (i.e. gas stations, consulting firms, etc). When it comes to measure of performance/return no one ever asks for the cap rate of a gas station or a consulting firm. They do however ask for some variation of profit margin, yield, etc. Incidentally, the formula of the metric Operating Yield on Cost is identical to cap rate (i.e. NOI/Cost).

IMO, the cap rate definition on Investopedia is wrong. It is unfortunate that when you google "cap rate" the Investopedia cap rate definition usually comes up high in the search result so people read it and think that cap rate is a measure of performance/return. Worse yet, they perpetuate this incorrect definition by referring other people to it.

Cheers... Immanuel.

I have an idea, how about every just type it in Google and then copy the first answer that pops up, haha.

@John Erlanger just curious why you say it is not an expected rate of return, assuming cash purchase? NOI is net operating income, so assuming you paid $100,000 cash for a property and got $10,000 NOI, that would be 10% return or 10% cap rate.

My take on CAP rate is that it can be useful for evaluating larger apartments or commercial real estate, but it has less value for single family homes or small multifamily. It is really just one of many different numbers you can use for quick evaluation. I think sometimes people get hung up on these "fast rules" like cap rate, 1% rule, 50% expense rule, etc. These are just meant to be high level evaluation tools to quickly gauge a property. You really need deep analysis of all expenses, income and financing terms to conclude the true return of any investment.

Originally posted by @Joe Splitrock :

I have an idea, how about every just type it in Google and then copy the first answer that pops up, haha.

Yeah, but if it's Google, on top of the list will be a sponsored message from a Russian bot declaring Trump is fixing CapRates as a favor to Putin.

 

Originally posted by @John Erlanger :
Originally posted by @Immanuel Sibero:

 



 

I'm with the Wikipedia definition in that Capitalization Rate is a valuation measure. Cap rate is a rate at which a certain type of income (i.e. in this case NOI -> Why do we pick NOI? This deserves another post!) is capitalized into value. An easier way to look at this, cap rate is a rate that converts a dollar of NOI into x dollars of VALUE. That's all cap rate does! For a lack of better word, it is really a conversion rate! It converts NOI into VALUE 

 

Cheers... Immanuel.

Maybe people would understand it better if it was called a conversion rate!  Then it would be referred to as a con rate which is mostly how it is used against novices.   Ha Ha

Absolutely appropriate, especially on those Turnkey SFR's advertisements...

Originally posted by @Joe Splitrock :

I have an idea, how about every just type it in Google and then copy the first answer that pops up, haha.

The good thing about Google is you can find everything on it. The bad thing about Google is ... you can find everything on it.

Cheers... Immanuel

 

Yeah if someone just dismisses a deal because it has a low cap rate they are missing part of the picture. 

One secret is if you can parse out valued where others miss, this will give you an edge.

There are so many other variables to factor in.

Like financing [commercial, residential, owner carry]- Interest rates, terms etc.

ie: Owner occupied 4 plex vs an investor owned - Same price - totally different metrics and outcome.

What is the future upside, can you increase revenue. Can you add sq footage [now can you convert or add an ADU] What is the lot size has a better function of value that might not represent future upside.

Can you create a higher and better use of the property. Is it in the path of progress. Can you invest and be in the path of progress. 

Here are some other terms that is a good idea to familiarize with that will affect your CAP rate and your overall strategy.

NOI - Net Operating income

GRM - Gross Rent Multiplier

CASH on CASH - How much income to you make on cash invested

Originally posted by @John Erlanger :

an expected rate of return, assuming cash purchase?

@Joe Splitrock

@Greg Dickerson

@Ivan Barratt

@Paul Moore

Joe, you realize that the cap rate will be the same no matter what the financing is?  That is because it is not a return measurement.  I see where you have come to this incorrect conclusion since there are BP people that proclaim this when they should know better.  

Maybe this will help put this incorrect notion to bed, 

@Brian Burke

https://www.biggerpockets.com/...

 I used the word cash multiple times to be super clear that cap rate gives you one year projected rate of return, without financing in the equation. Of course financing changes the equation. I was clear on that, so why throw it at me and claim that is the smoking gun that makes my comment wrong? 

Cap rate uses NOI, which is net operating income. If you purchased a property with all cash, it is a fair expectation that your projected cash rate of return in year one would be around the cap rate. The math is pretty simple, so I don't see how this statement is incorrect.

Cap rate is a high level way to compare different investments without financing in the equation. Your actual return over time depends on many variables, one of which is financing. 

I honestly never knew cap rate was an item to debate. Scour the internet and hundreds of people agree with my general comments. 

Originally posted by @John Erlanger :
Originally posted by @Joe Splitrock:
Originally posted by @John Erlanger:

an expected rate of return, assuming cash purchase?

@Joe Splitrock

@Greg Dickerson

@Ivan Barratt

@Paul Moore

Joe, you realize that the cap rate will be the same no matter what the financing is?  That is because it is not a return measurement.  I see where you have come to this incorrect conclusion since there are BP people that proclaim this when they should know better.  

Maybe this will help put this incorrect notion to bed, 

@Brian Burke

https://www.biggerpockets.com/...

 I used the word cash multiple times to be super clear that cap rate gives you one year projected rate of return, without financing in the equation. Of course financing changes the equation. I was clear on that, so why throw it at me and claim that is the smoking gun that makes my comment wrong? 

Cap rate uses NOI, which is net operating income. If you purchased a property with all cash, it is a fair expectation that your projected cash rate of return in year one would be around the cap rate. The math is pretty simple, so I don't see how this statement is incorrect.

Cap rate is a high level way to compare different investments without financing in the equation. Your actual return over time depends on many variables, one of which is financing. 

I honestly never knew cap rate was an item to debate. Scour the internet and hundreds of people agree with my general comments. 

 You asked me about a cap rate and why I say it is not a return.  There is no debate except from some people that don't understand what it is or they know but want to trick people.  Not trying to throw you under the bus but to show you that cap rate is not what you think it is.  Is that fair in answering your question?

You are just repeating your flawed thinking and have not addressed the examples I gave that clearly show that a cap rate does not measure return.  I also linked a blog of @Brian Burke that also clearly shows that a cap rate is not a return.  You are also clearly ignoring direct capitalization which is where cap rates come from.

Can you answer this question. If a seller is selling $100,000 NOI in Ohio for $1,000,000. And a seller is selling $100,000 NOI in CA for $2,000,000 that is a 10% cap rate and a 5% cap rate. Can you explain to the Ohio seller why he is getting half the price for twice the "return" than what the CA seller is getting? Assuming they both got cash and that the cap rate is a "return".

Yes if they both paid cash, they could expect their first year rate of return to be the cap rate. (Do you dispute that statement and if so show the math please.) Over time, I would expect the California property to have more appreciation in rents and appreciation in property value. When you sell the California property, the overall return may be higher. The longer you hold the property, the more likely that is true.

I never said buying something with a higher cap rate was a better investment. Many other factors are important such as financing, hold strategy, property condition, opportunities for unlocking value, expected appreciation, etc. 

Of course saying a lower cap rate makes something a better investment is also oversimplification. Anyone can offer their property up for sale at whatever cap rate they desire. There is no rule that you need to sell or buy at market cap rate, but market cap rate does establish fair market value. There are also many strategies in real estate. Some people look for short term cash flow over longer term appreciation.

@Rob Massopust

I have not seen GRM used in a long time. You see it mentioned in some of the older real estate investing books from the ‘80s. I'm curious if anyone is currently using it to value SFH and small MF. What in your opinion is a "good" GRM?

I guess the 1% rule is a crude version of GRM. 1% rule ~ 83 GRM.