Can you define cap rate for the purpose of income property?

In Market Conditions - Asked by Michael E. - May 21, 2010
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Answer(s)

Erica B.
Corporate Investor
Grafton, WV

Cap Rate is short for Capitalization Rate. Cap rate is the ratio between the net operation income produced by an asset and its capital cost. Capitalization Rate = Annual net operating income divided by cost or value of the property. For Example if a building is purchased for $100,000 and it produces $10,000 in positive net operating income then the cap rate is 10%. Positive net operating is monthly rents times twelve months, less taxes, insurance, utilities paid by landlord, ground maintenance etc.

May 21, 2010
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kirk s.
Broker/Agent
Wichita, KS

I saw a great explanation of what you should consider in this market when buying commercial property...regardless of whether it is commercial or Multi Family! It is as follows:
Jeffrey S.
Owner/Investor
Longmont, CO
How about forgetting about comparable cap rates and calculate a price that the property can afford to pay in relation to your cost of financing?
Debt Coverage Ratio: DCR
Annual Mortgage Constant: AMC (the blended cost of all debt that will be on the property)
Loan to Value ratio: LTV (the combined debt divided by the price)
Capitalization rate: CAP = DCR * AMC * LTV
Then divide the actual NOI by your calculated CAP and that's your maximum allowable offer price. Offer not more than the lesser of the asking price or the calculated price, and you may want to start negotiations about 10% to 20% below that amount.
I suggest a DCR of not less than 1.5 to accommodate recessionary pressure on income and expenses. That will allow enough cash flow margin to handle downturns in NOI.

May 21, 2010
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Rob B.
Chandler, AZ

It is suggested that if you have a fundamental question of the definition of a cap rate that you may want to consider a mentor that can guide you, since cap rates are only the tip of the investment iceberg and you do not want to be on the investment equivalent of the Titanic.
If you are in the industry there are many ways to associate with a good mentor. If you are an independent investor, there are terrific professionals in our industry that would be more than happy to educate you on their skills, as they lead you toward good buys in a particular market in any given economic time. In up or down cycles, the use of cap-rates change in relationship to many financial factors.
Rob Baird CA RE License #544165 (One of the oldest RE Licenses in CA)
951 515-5855

May 22, 2010
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Bert F.
Broker/Agent
Boynton Beach, FL

A Cap Rate, or Capitilzation Rate, is a measure of anticipated Return On Investment (ROI) that one is considering investing. As a calculation, it is the Net Operating Income (NOI) divided by the price that the property will be purchasedd for. It does not take into account the debt on the property, since the size of the mortgage and it's interest rate and terms will vary for each buyer. By excluding debt coverage from the Cap Rate it provides a consistent comparable ROI - or Cap RAte - for properties. The Cap Rate is also a measure of risk. The higher the Cap Rate the higher the risk and the lower the price an investor will be willing to pay. Conversely, the lower the Cap Rate, the safer the invetment is preceived and therefore, the higher the price an invetor will be willing to pay. The NOI used in the Cap Rate calculation should take into conideration reserves, leasing fees, vacancy factor and replacement fund for items such as new roof, A/C system and parking lot.

May 24, 2010
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Alan Y.
Property/Asset Manager
Woodland Hills, CA

The simple answer is that a cap rate is the cash return that a property generates figured as a percentage of a purchase price paid in all cash (with no debt). The amount includes all income less all operating expenses (and does not include a mortgage payment or capital improvements). The existence of debt may decrease cash flow and increase a return on investment, but does not affect the cap rate...
I hope that helps.

May 24, 2010
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Jennifer D.
Broker/Agent
Danvers, MA

Both Eric & Bert say it best. But I just kinda skimmed the rest so I'm not sure if anyone mentions this or not. The CAP rate also measures the return on the investment had the investor paid cash for the property.
Brian Dapice
KW Commercial

May 31, 2010
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Michael C.
Bolton, MA

Bert, don't you have that backwards? Cap rate is NOI divided by purchase price, so the cap rate increases as the NOI increases or as the purchase price decreases, both of which are good things. So why would investors pay less for a high cap rate and more for a low cap rate rather than the other way around?

Jan 28, 2013
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