Understanding Cap Rates

If you are wishing to invest in a commercial property, do you know how to assess if it’s a good price? If you are new to investing, understanding cap rates can be a critical piece of the puzzle.

Perhaps you have bought and sold a primary residence in the past and you saw how the home was valued based on a comparative market analysis (CMA), or simply, what the neighbor’s home sold for recently. Such a comparison is the norm for single-family units. But commercial real estate isn’t valued that way at all. Each commercial asset has a lot of variables involved that can make such simplistic comparisons of value unreliable. Instead, commercial assets are valued on their ability to generate cash flow.

Defining NOI, Value, Capitalization rate

To examine this further, we’ll need to define some terms:

• NOI (net operating income) is essentially calculated as gross income minus operating expenses, but NOI does not take into account debt service or investor distributions. Rather, it’s a common means to understand the potential of an asset to generate income.
• Value is the market perception of what the asset is worth if it were to be sold.
• Capitalization rate (cap rate) is simply the NOI divided by the Value. So an asset worth 1 million that produces 60k annual NOI has a 6% cap rate.

Based on these terms, we can use the following formula (I promise, no pop-quiz at the end):

Cap rate = NOI/Value

If we want to know the cap rate of an existing asset, we simply divide the NOI by the value for which we purchased the asset. This gives us a simple metric of the asset’s ability to generate cash flow.

That’s simple enough, but what if we don’t know the value of something?

Some simple algebra turns the previous equation around:

Value = NOI/Cap rate

But the cap rate has now reversed roles; it’s now something we need to know in order to determine value. 

The NOI is easy to get from looking at the books to see the performance of an asset to generate income.

This should immediately raise a question. 

In our first formula (equation) cap rate was something we calculated, but cap rates are also something that is determined by the market. Isn’t this circular reasoning? Not quite.

The two uses of cap rates

1. As we initially indicated, cap rates are a quick assessment of how a property is financially performing if you already know the property’s value (ex. what it was just purchased for). Given NOI and property value, cap rate simply says how well an asset produces cash flow.
2. Cap rates also represent what purchasers, investors, and banks view as “acceptable rates” of cash flow. These rates are subject to the related market, demand, asset condition, and consideration of what risk is acceptable (which may have nothing to do with any prior valuation).

As an example, consider an investor who owns a property that was purchased 3 years ago for 1 million dollars and is now producing NOI of 60,000 per year. The math indicates it’s a 6% cap rate. However, if the market is such that market, demand, and risk for the asset held by the investor are currently viewed by new investors and banks to be 4% (perhaps there is a housing shortage for multifamily units) then the new valuation would be 60,000/4%, or 1.5 million.

If you were one of the investors in this example, and the property was purchased with a $250L capital raise and $750K of bank financing, then its new valuation (if it sold) would bring in 1.5 million – 750K for a net of 750K on the original 250K investment – also expressed as a 3x on the investment. Not a bad return for 3 years!

Cap rates can go up and down so it’s essential to understand where the market is when making buy or sell or invest decisions.

From this discussion, we conclude that when it comes to cap rates, it’s best to buy high and sell low – quite the backward of our normal view of investing! Thankfully, math never lies. It still holds true that for value, we want to buy low and sell high. The confusion primarily revolves around the fact that “cap rate” is a term that gets flipped around, depending on the formula you’re using to better understand an investment’s potential.

In summary 

While cap rates can be confusing to understand at first, the primary takeaway is that a lower cap rate can result in much higher returns for real estate investors. “Buy high, sell low” in this case is a great advantage. And while we as investors can’t control the market cap rates, we do need to be aware of how they affect the value of what potential investments. 

If you are looking to understand more about cap rates, net operating income, or value in greater detail, we would love to connect with you! 

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