Commonly referred to as a ‘cap rate’, the capitalization rate is a benchmark in valuation methodology often used for commercial real estate investments. This method is generally used and accepted by lenders, appraisers, and real estate investors.

The cap rate is the relationship between the investment’s net operating income and its value. Net operating income is the remaining revenue from the property less all reasonably necessary operating expenses. Note – debt servicing is not part of the equation. Users of the cap rate method pay close attention to the profit-loss statement to ensure net operating income is accurate to, in turn, allow for an accurate calculation of cap rate. For example, a $5,000 difference in net operating income with an investor seeking a 6% cap rate can result in $83,333 dollars of difference in property valuation. It should also be noted that different asset classes (multifamily, retail, office) will have different cap rate that is acceptable for that market/trade area.

Equation

NOI/Value = Cap Rate

Example

An investor is considering purchasing a property with a forecasted first-year NOI of $50,000. The investor has established a cap rate requirement of 9.75% based on similar properties. What would this investor consider paying for the property?

NOI ($50,000)/R(0.0975) = V($512,821)

The investor will consider paying $512,821 for this property using the cap rate of 9.75% to determine investment value. The advantage of using this valuation method is its simplicity in calculation and the fact that it accounts for vacancy and credit losses and operating expenses; unlike alternative valuation methods, such as gross rent multiplier. On the other hand, because of its simplicity, it has certain limitations to its reliability: since the cap rate does not consider financing or tax impact. Additionally, the cap rate only takes into account a one-year forecast when determining value or measuring performance. A common misconception when using the term cap rate is that some investors assume that the overall cap rate is equal to the return on their invested capital. This is rarely the case.

While the cap rate can be a useful valuation tool for commercial real estate, investors should be aware of its drawbacks: it does not tell you everything about the investment going into the future. Therefore, investors should take into consideration a multitude of factors and valuation methods to determine their purchase decision.

The content of this article is meant for informational purposes only. It is not meant to provide any financial, business, commercial, or legal advice. Readers are encouraged to discuss all matters with a commercial realtor or lawyer for all particular situations involving the content of this article.

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