- Basics of Cap Rates
- The Cap Rate Formula
- Cap Rate: An Indication of Property Value
Basics of Cap Rates
Investors commonly calculate the return on investment or ROI using the capitalization rate, commonly called the Cap Rate or CAP. The cap rate is defined as the rate of return on a real estate investment property based on the income the property is expected to generate. The Cap Rate estimates an investor’s annual return on their investment. Here is the formula typically used for commercial real estate Cap Rate calculations:
The Cap Rate Formula
Capitalization Rate = Net Operating Income (NOI) / Current Market Value
First, the real estate professional needs to know the Net Operating Income (NOI) or the value that shows the investment property’s total positive generated income. Specifically, NOI is what investors have after paying Operating Expenses (variable costs and fixed costs) from Gross Income. Here is the formula for calculating NOI:
NOI = Gross Income – Operating Expenses
How to Find Cap Rate With NOI
As stated above, the Cap Rate estimates the annual return on a specific investment. The calculation is mainly used because it helps determine a real estate investment’s profitability. On a basic level, Cap Rate shows how an asset’s NOI relates to its value.
In the example above, the property’s operating expenses are one of the most important figures for determining the Cap Rate. Operating expenses include taxes, property management costs, insurance, and maintenance fees. Once the operating expenses are figured out, an investor can find the Cap Rate.
For instance, investors need the Cap Rate if they wish to buy an apartment complex. Residents pay a monthly rent to live on the property. At the same time, the owner is responsible for the monthly operating expenses. In this example, the NOI is the tenant’s rent minus the apartment complex’s expenses.
At the end of a specific period (either the month or year), the investor will need to know how much money remains after paying these expenses. Simply put, this is the most critical number to know – the profit.
CAP RATE CALCULATOR BASED ON NOI
When an investor wants to purchase a commercial property, they want to know the potential income. Whether it’s an office space, commercial retail space, or an apartment complex, having a solid idea about the investment’s return is crucial. Furthermore, this is especially true when comparing similar properties.
A Practical Example
If an investor purchases a building at the current market value of $1M and this investment creates $100,000 of annual NOI, then this formula is true:
$100,000 / $1,000,000 = 0.10 (10%)
The Cap Rate is 10%. In other words, the investor will pay one-tenth of the property value’s total cost with that year’s NOI.
A Word of Caution
Without a doubt, Cap Rate is a successfully proven approach for finding the value of a commercial real estate investment. Yet, as a real estate investor, it is important to remember the following: when using Cap Rates, it is wise to use them alongside other valuation methods.
When determining the next investment’s quality, it is a good idea to consider at least one other valuation approach – market comparison, gross rent multiplier, or even value per door. This, alongside the Cap Rate, will give a better, more accurate property valuation before buying or selling.
Cap Rate: An Indication of Property Value
Cap Rate is the percentage of annual return an investor could expect to receive on a cash purchase. At the same time, this straightforward formula doesn’t account for other things. When comparing two or more investment properties, a lower Cap Rate points to higher property values and vice versa.
Example: Find the Cap Rate for an Office Building
If the NOI is not published for a certain property, a licensed commercial real estate agent can help you find that information.
Using an office building as an example below, the cap rate is found using the property’s income, NOI of comparable office properties, and the recent selling prices of comparable commercial properties. Check it out:
Office buildings in the Uptown Galleria submarket, one of Houston’s upscale markets, lease for much more than offices in nearby office submarkets like the Southwest Freeway.
It is important to note that NOIs aren’t always published, and a commercial real estate agent or local tax office may need to be contacted for sales data.
After determining the office building’s expenses, a solid comparison between similar properties can be made. In the end, this comparison of properties reveals discrepancies in property costs (either real or perceived). As The Balance says, “When two properties seem just alike and one costs more, it could be because it is generating more income or has lower expenses.”
Is There an Ideal Cap Rate?
Twenty years ago, investors could expect a 10% Cap Rate for commercial investments. However, these days that number is more or less a dream. Since 2002, the average Cap Rate for multifamily properties in both major and minor markets has steadily fallen. For example, in 2002, Cap Rates hovered around 8%. Yet by Q3 2018, rates had declined to around 5%.
Reasons to Use Cap Rates
Without a doubt, there are other ways to value potential investments. However, Cap Rate is frequently a quick, easy way to estimate value with advantages over other methods. Apart from being a widely used metric, in general, Cap Rate:
- includes revenue and expenses
- reflects supply and demand for a particular type of asset in a specific at a given time
- reflects the asset grade
- may be connected to the debt’s interest rate
Reasons to Not Use Cap Rates
As seen above, Cap Rate is a simple and helpful calculation. Specifically, it lets investors quickly size up a commercial real estate property. However, in some scenarios, the Cap Rate isn’t as useful.
For example, if the property’s NOI is either irregular or complex (or both), the cap rate probably isn’t the best option. So, although the Cap Rate gives a quick ‘back-of-the-napkin’ calculation, it may not represent the property as accurately as other calculations.
Is Cap Rate Different From ROI?
Yes. In general, the cap rate helps compare properties, while ROI is useful for analyzing individual properties. The ROI is the overall rate of return on a property, including debt and cash invested.
Unlike the cap rate, ROI considers the property’s debt. Specifically, ROI accounts for your out-of-pocket costs – down payment, closing costs, improvements, and other costs of purchasing the property. Overall, 10% is a good ROI for investment properties. Be aware that the number may seem larger if a property is mortgaged. Below is the formula for calculating ROI:
ROI = Annual Return / Total Investment x 100
Example: Find the ROI
An investor purchases a property for $250,000 and the annual return is $35,000. Using the formula, here’s how to calculate ROI:
$35,000 / $250,000 x 100 = 14%
In this scenario, the investor would have a 14% ROI on the investment property, making it a solid investment.
At CXRE, we take pride in helping our clients maximize their investment potential. Eliminate the complications of determining the value of a commercial real estate property for investment purposes and trust we will obtain the correct and fair accurate value. Contact us today for more information!